Week 12Corporate-Level Strategy: Creating Value through Diversification

Revision of last lecture

• 3 generic strategies - overall cost leadership, differentiation, and focus

• Integrate strategy into value chain– Students should also know how to integrate strategy with RBV

model

• Advantages & disadvantages (5 forces model)– Potential dangers / pitfalls

• The importance of product life cycle to a firm’s business-level strategy

Learning Objectives

• Diversification– Related diversification– 4 means to create value

• Leveraging core competencies, Sharing activities, Pooled negotiating power, Vertical integration

– Unrelated diversification• Corporate parenting• Restructuring• Portfolio analysis

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Main Questions in Diversification

• What businesses should a corporation compete in?

• How should these businesses be managed to jointly create more value than if they were freestanding units?

Business level vs. corporate level strategy

• Business-level strategy is dealing with one particular business unit

• Corporate-level strategy may deal with multiple business units

3 forms of corporate strategy

Single-business strategy

• Definition:– A firm that adopts this strategy relies on a single business,

product, or service for all its revenue

• Examples:– Coca-Cola, McDonalds, Sears

• Major Advantage:– Concentration on one product or service

• Major disadvantage:– Vulnerable to (unforeseen) changes in the external

environment e.g. technological developments

Diversification

• Definition:– The process of adding new businesses to the company

that are distinct from its established operations

– E.g. MTR (public transport + real estate)

But this may not be always the case…

• Some succeeded…– British Petroleum/Amoco and Arco– Exxon/Mobil– Renault-Nissan alliance

• Some failed…– AOL/Time Warner– Quaker Oats/Snapple– AT&T/NCR– Sony/Columbia Picture

Diversification Failure is Common A study evaluated the stock market reaction of 600 acquisitions

over the period between 1975 and 1991. The results indicated that the acquiring firms suffered an average 4% drop in market value in the three months following the acquisition announcement

In a study by Solomon Smith Barney of US companies acquired since 1997 in deals for $15 billion or more, the stocks of the acquiring firms have, on average, underperformed the S&P stock index by 14% points and underperformed their peer group by 4% points after the deals were announced.

AOL paid $114 billion to acquire Time Warner in 2001. Over the next two years, AOL Time Warner lost $150 billion in market valuation.

Making Diversification Work

• Diversification initiatives must create value for shareholders– Mergers and acquisitions– Strategic alliances– Joint ventures– Internal development

• Diversification should be synergistic

Making Diversification Work

• Diversification should create synergy

Business 1

Business 2

Making Diversification Work

• Related businesses (horizontal relationships)– Sharing tangible resources– Sharing intangible resources

• Unrelated businesses (hierarchical relationships)– Value creation derives from corporate office– Leveraging support activities

Related Diversification

• A firm entering a different business in which it can benefit from leveraging core competencies, sharing activities, or building market power.

• Economies of scope: cost saving from– Leveraging core competencies– Sharing related activities among businesses in the

corporation

Related diversification – example: Nestle

Leveraging Core Competencies• Core competencies

– a firm’s strategic resources that reflect the collective learning in the organization

– The glue that binds existing businesses together– Engine that fuels new business growth– Collective learning in a firm

– How to coordinate diverse production skills– How to integrate multiple streams of technologies– How to market diverse products and services

3M leverage its core competencies

• Adhesives technologies• Applied in many industries: automotive,

construction, telecommunication

Three Criteria of Core Competencies

• 1) Core competencies must enhance competitive advantage(s) by creating superior customer value

• Develop strengths relative to competitors• Build on skills and innovations• Appeal to customers

Example: Gillette• Scientists developed the Fusion and Mach3 after

the introduction of the tremendously successful Sensor System because of a thorough understanding of several phenomena that underlie shaving.

Three Criteria of Core Competencies

• 2) Different businesses in the firm must be similar in at least one important way related to the core competence

– Not essential that products or services themselves be similar

– Is essential that one or more elements in the value chain require similar essential skills

Cars and houses, any in common?

Three Criteria of Core Competencies

• 3) Core competencies must be difficult for competitors to imitate or find substitutes for

• Easily imitated or replicated core competencies are not a sound basis for sustainable advantages

• Specialized technical skills acquired only in company work experience are an example

An example: Sharp Corporation

• USD 26 billion consumer electronics giant• A set of specialized core competencies in

optoelectronics technologies• Most successful technology, LCD, in nearly all of

Sharp’s products– VCRs– Wizard: a personal electronic organizer

Question The concept of core competencies can be

illustrated by the imagery of the diversified corporation as a tree. Describe what the different parts of a tree would represent in a corporation.

Sharing Activities• Corporations can also achieve synergy by

sharing tangible and value-creating activities across their business units– Common manufacturing facilities– Distribution channels– Sales forces

• Sharing activities provide two payoffs– Cost savings: elimination of jobs, facilities, and related

expenses– Revenue enhancements

McKesson: sharing activities

• A large distribution company• Sells many product lines, such as

pharmaceuticals and liquor, through its super warehouses

Gillette acquired Duracell and Parker Pen

• Selling Duracell batteries through Gillette’s existing channel for personal care products

• Gillette gained additional revenue in sales of its own Waterman pens by taking advantage of Parker’s distribution channels

Related Diversification: Market Power• Market power

– firms’ abilities to profit through restricting or controlling supply to a market or coordinating with other firms to reduce investment

• Two principal means to achieve synergy through market power– Pooled negotiating power– Vertical integration

Nevertheless, government regulations may restrict this power

• GE’s bid for Honeywell• European Union stepped in• GE could use increased market power to

dominate the aircraft engine parts market

Pooled Negotiating Power• Similar businesses working together can have

stronger bargaining position relative to– Suppliers– Customers– Competitors

• Example of Nestlé– Being an independent food manufacturer with the

same business within Nestlé– It is part of a firm that makes large purchases from

suppliers and provides a wide variety of products to its customers

Pooled Negotiating Power• Procter & Gamble

– Haircare Pantene, Head & Shoulders, Clairol– Household cleaning/care Flash, Febreze, Fairy– Laundry Daz, Ariel, Fairy, Bounce– Paper Bounty, Pampers, Allways– Beauty Oil of Olay, Max Factor– Beverages Sunny Delight– Snacks Pringles Petfood Iams

Vertical integration

• A firm becomes its own supplier or distributor• An automobile manufacturer might make its

own engines• An oil refinery might develop its own drilling

capacity

Vertical integration

Raw materials Manufacturing of final product Distribution

Polypropylene fiber production

Carpet manufacturing Retail stores

Backward integration

Forward integration

But……

• McDonald’s may be the world’s biggest buyer of beef, but they do not raise cattle

Vertical Integration: Benefits and Risks

Making Vertical Integration Decisions1. Are we satisfied with the quality of the value that our

present suppliers and distributors are providing?

2. Are there activities in our industry value chain presently being outsourced or performed independently by others that are a viable source of future profits?

3. Is there a high level of stability in the demand for the organization’s products?

4. Do we have the necessary competencies to execute the vertical integration strategies?

5. Will the vertical integration initiative have potential negative impacts on our stakeholders?

Analyzing Vertical Integration: Transaction Cost Perspective

• Definition: the choice of a transaction’s governance structure, is influenced by transaction costs, such as search, negotiating, contracting, monitoring, and enforcement costs

• Every market transaction involves some transaction cost

• These transaction costs can be avoided by internalizing the activity when transaction costs are higher than administrative costs

Analyzing Vertical Integration: The Transaction Cost Perspective

Negotiating costsNegotiating costs

Search costsSearch costs

Enforcement costsEnforcement costs

Monitoring costsMonitoring costs

Costs of written contract

Costs of written contractMarket

transaction

Unrelated Diversification: Financial Synergies and Parenting

• a firm entering a different business that has little horizontal interaction with other businesses of a firm.

• Two main sources of such synergies– Parenting and restructuring of businesses– Portfolio management: allocate resources to optimize

corporate goals

Corporate Parenting & Restructuring• Corporate Parenting

– the positive contributions of the corporate office to a new business as a result of expertise and support provided by the corporate office

• Corporate Restructuring-’buy low sell high’– The intervention of the corporate office in a new

business that substantially changes the assets, capital structure, and/or management• Asset restructuring: sale of unproductive assets• Capital restructuring: change the debt-equity mix• Management restructuring: changes in composition of top

management team

Corporate Parenting: Cooper Industries• New acquisitions are “Cooperized”

– audits their manufacturing operations– improves their cost accounting systems– makes their planning, budgeting, and human resource

systems conform with its systems

• “when you get acquired by Cooper, one of the first things that happen is a truckload of policy manuals arrives at your door.”

Corporate Restructuring: Loews Corp.

• Successfully “buy low and sell high”• Bought six oil tankers for only $5 million each and

sold them for $50 million each eight years later• the insight to detect undervalued companies• The requisite skills and resources to turn the

businesses around

Portfolio Management

• Portfolio management– assessing the competitive position of a portfolio of

businesses within a corporation– suggesting strategic alternatives for each business– identifying priorities for the allocation of resources

across the businesses

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Portfolio Management Creating Value

• Allocate resources• Expertise of corporate office in locating attractive

firms to acquire• Provide financial resources to business units on

favorable terms reflecting the corporation’s overall ability to raise funds

• Provide high quality review and coaching for units• Provide a basis for developing strategic goals and

reward/evaluation systems

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Portfolio Management: BCG matrix

Means to Achieve Diversification

• Acquisitions or mergers• Pooling resources of other companies with a

firm’s own resource base– Joint venture– Strategic alliance

• Internal development-corporate entrepreneurship– New products– New markets– New technology

Mergers and Acquisitions• Corporations directly acquire a firm’s assets and

competencies• Competing firms often can imitate any advantages realized

or copy synergies that result from the M&A.• There can be many cultural issues that may doom the

intended benefits from M&A endeavors

Limitations

• Competing firms often can imitate any advantages realized or copy synergies that result from the M&A.

• There can be many cultural issues that may doom the intended benefits from M&A endeavors.

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Strategic Alliances & Joint Ventures• Introduce successful product or service into a

new market– Lacks requisite marketing expertise

• Doesn’t understand customer needs• Doesn’t know how to promote the product• Doesn’t have access to proper distribution channels

• Join other firms to reduce manufacturing (or other) costs in the value chain– Pool capital– Pool value-creating activities– Pool facilities

Strategic Alliances & Joint Ventures

• Develop or diffuse new technologies– Use expertise of two or more companies– Develop products technologically beyond the

capability of the companies acting independently

Unmet Expectations: Strategic Alliances and Joint Ventures

• Improper partner– Each partner must bring desired complementary

strengths to partnership– Strengths contributed by each should be unique

• Partners must be compatible• Partners must trust one another

Managerial Motives Can Erode Value Creation

• Growth for growth’s sake• Egotism• Antitakeover tactics

– Greenmail– Golden parachute– Poison pills