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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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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)

GE s 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 care8 4

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

GEs Changing Geographic Scope

Source: Author s depiction of data in GE annual reports. 8 6

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What Is Corporate Strategy?

Corporate strategyCorporate strategy is the way a company creates value through theconfiguration and coordination of its multi-market activitiesQuest for competitive advantage when competing in multiple industries

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

Corporate strategy concerns the scope of the firm

Industry value chainProducts and services

Geography

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EXHIBIT 8.1 Three Dimensions of Corporate Strategy

Scope o f the f i rm determines 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 organizeeconomic activity.

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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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 costsCosts associated with economic exchanges

Either in the firm OR in the marketsEx: negotiating and enforcing contracts

Administrative costsCosts pertaining to organizing an exchange within ahierarchy

Ex: recruiting & training employees

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Firms vs. Markets: Make or Buy

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

If Cin-house < C market , then the firm should ver t ica l ly in tegrate

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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STRATEGY HIGHLIGHT 8.1 Toyota Locks Up Lithiumfor Car Batteries

World demand for lithium-ion batteries for carsGrow 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 areaUpfront investment to extract of lithium is very high

Should Orocobre make the investment to supply Toyota?To encourage investment, Toyota took anequity 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 8-2 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.





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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 integrationEx: Weyerhaeuser

Owns forests, mills, and distribution to retailers

Backward vertical integrationEx: HTC s backward integration into design of phones

Forward vertical integrationEx: HTC s forward integration into sales & branding

Not all industry value chain stages are equal ly prof i tab leZara primarily designs in-house & partners for speedynew fashions delivered to stores

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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 assetsEx: HTC started as OEM & expanded to fully integrated 8 22

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Benefits of Vertical Integration

Specialized assets Assets that have significantly more value in theirintended use than in their next best use

Types of specialized assetsSite specificity

Co-located such as coal plant andelectric utility

Physical asset specificityBottling machinery

Human asset specificityMastering procedures of a particular organization

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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, andin-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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Alternatives to Vertical Integration

Taper integrationBackward integrated but also relies on outside market firmsfor supplies

OR

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 tomany firms that choose to outsource it.

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EXHIBIT 8.6 Taper Integration along the Industry Value Chain

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

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Risks in undertaking cooperativeagreements or strategic alliances

Adverse selectionPartners misrepresent skills, ability and otherresources

Moral HazardPartners provide lower quality skills andabilities than they had promised

HoldupPartners exploit the transaction specificinvestment made by others in the alliance

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Corporate Diversification:Expanding Beyond a Single Market

Degrees of diversificationRange of products and services a firm should offer

Ex: PepsiCo also owns Lay's & Quaker Oats .

Diversification strategies :Product diversification

Active in several different product categoriesGeographic diversification

Active in several different countriesProduct market diversification

Active in a range of bo th product and countries

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EXHIBIT 8.7 Different Types of Corporate Diversification

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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 8 32
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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LO 8-8 Explain when a diversification strategy creates a competitiveadvantage, and when it does not.

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Motivations For Diversification

Value Enhancing Motives :

Increase market powerMulti-point competition

R&D and new product developmentDeveloping 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 strengths Allows firms to increase the value of product/serviceLowers the cost

Examples: Wal-mart global supply chainInfosys low-cost global delivery system

The core competence market matrixProvides guidance to executives on how to diversifyin order to achieve continued growth

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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 problemManagerial capitalism (empire building) Maximize management compensationSales 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) Kaiser Aluminum; and (3) Kaiser Cement were independentcompanies and the stock of each were publicly traded.Kaiser Industries was selling at a discount which vanished

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EXHIBIT 8 9 The Di ersification Performance Relationship

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EXHIBIT 8.9 The Diversification-Performance Relationship

V i l I i d Di ifi i

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EXHIBIT 8.10 Vertical Integration and Diversification:Sources of Value Creation and Costs

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EXHIBIT 8.11 BCG Matrix

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Corporate Diversification

Internal capital marketsSource of value creation in a diversification strategy

Allows conglomerate to do a more efficient job ofallocating 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

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Oracle Corporate Strategy: Combining

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EXHIBIT 8.12 Oracle Corporate Strategy: Combining Vertical Integration and Diversification

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P bl iP bl iP bl i

R fR f

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Ch7-3

Problems inAchieving Success

Problems inProblems inAchieving SuccessAchieving Success

IntegrationIntegration

difficultiesdifficulties

InadequateInadequateevaluation of targetevaluation of target

Too muchToo muchdiversificationdiversification

Large or Large or

extraordinary debtextraordinary debt

Inability toInability toachieve synergyachieve synergy

Managers overlyManagers overlyfocused on acquisitionsfocused on acquisitions

Too largeToo large

IncreasedIncreased

market power market power

OvercomeOvercomeentry barriersentry barriers

Lower risk Lower risk compared to developingcompared to developingnew productsnew products

Cost of newCost of new

product development product development

Increased speedIncreased speedto marketto market

IncreasedIncreaseddiversificationdiversification

Avoid excessiveAvoid excessivecompetitioncompetition

AcquisitionsAcquisitions

Reasons forReasons forAcquisitionsAcquisitions

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Sustainable Competitive Advantage

Trying to gain sustainable competitive advantage viamergers 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$300 million.

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Under what scenarios can the bidder do well?

Luck

Asymmetric Information This eliminates the competitive bidding premise

implicit 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

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