CHAPTER 8 Corporate Strategy Vertical Integration and Diversification

Part 2 Strategy Formulation

LO 8 -1 Define corporate-level strategy, and describe three dimensions along which it is assessed. LO 8 -2 Describe and evaluate different options firms have to organize economic 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 different diversification strategies. LO 8 -8 Explain when a diversification strategy creates a competitive advantage, and when it does not.

Chapter Case 8 Refocusing GE: A Future of Clean-Tech and Health Care? • Jeffrey Immelt appointed CEO of GE Sept. 7 th 2001 Ø Environmental Change (e. g. , 9/11 and Global Financial Crises) Ø GE’s stock price fell by 84% Ø Lost AAA credit rating • Refocus on green economy and health care industries Ø Sold majority stake in NBC Universal to Comcast • “Ecomagination”: solar energy, hybrid locomotives, fuel cells…etc. • “Healthymagination”: increase quality and access to health care

Chapter Case 8 Refocusing GE: A Future of Clean-Tech and Health Care? GE’s Changing Product Scope

Chapter Case 8 Refocusing GE: A Future of Clean-Tech and Health Care? GE’s Changing Geographic Scope Source: Author’s depiction of data in GE annual reports.

What Is Corporate Strategy? • Corporate strategy Ø Corporate strategy is the way a company creates value through the configuration and coordination of its multi-market activities Ø Quest for competitive advantage when competing in multiple industries v Example: Jeffrey Immelt’s initiative in clean-tech and health care industries • Corporate strategy concerns the scope of the firm Ø Industry value chain Ø Products and services Ø Geography

What Is Corporate Strategy? • Three key dimensions: Ø What stages of industry value chain and degrees of vertical integration Ø What range of products and services and degrees of horizontal integration and diversification Ø Where in the world to compete and global strategy

EXHIBIT 8. 1 Three Dimensions of Corporate Strategy Scope of the firm determines boundaries along these 3 dimensions.

LO 8 -1 Define corporate-level strategy, and describe three dimensions along which it is assessed. LO 8 -2 Describe and evaluate different options firms have to organize economic 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 different diversification strategies. LO 8 -8 Explain when a diversification strategy creates a competitive advantage, and when it does not.

Transaction Cost Economics and Scope of the Firm • Transaction cost economics Ø Explains and predicts the scope of the firm Ø "Market vs. firms" have differential costs • Transaction costs Ø Costs associated with economic exchanges Either in the firm OR in the markets v Ex: negotiating and enforcing contracts v • Administrative costs Ø Costs pertaining to organizing an exchange within a hierarchy v Ex: recruiting & training employees

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 vertically integrate Ø Ex: Microsoft hires programmers to write code in-house rather than contracting out Ø Firms and markets have distinct advantages and disadvantages (see Exhibit 8. 2)

EXHIBIT 8. 2 Organizing Economic Activity: Firm vs. Markets

Firms vs. Markets: Make or Buy? • Disadvantage of “make” in-house Ø Principal – agent problem v owner = principal, manager = agent Ø Agent pursues his/her own interests • Disadvantage of “buy” from markets Ø Search cost Ø Opportunism Ø Incomplete contacting Ø Enforce legal contacts • Information asymmetries Ø One party is more informed than others v Akerlof – “Lemons problem” for used cars – Receiving Noble prize in Economics

EXHIBIT 8. 3 Alternatives along the Make or Buy Continuum

STRATEGY HIGHLIGHT 8. 1 Toyota Locks Up Lithium for Car Batteries • World demand for lithium-ion batteries for cars Ø Grow from $278 million in ‘ 09 to $25 billion in 2014 • Toyota wants to secure long-term supply of lithium to power its hybrid fleet • Orocobre holds exploration rights to a large salt-lake area Ø Upfront investment to extract of lithium is very high • Should Orocobre make the investment to supply Toyota? Ø To encourage investment, Toyota took an equity position 1– 16 China Rare Earth Video

LO 8 -1 Define corporate-level strategy, and describe three dimensions along which it is assessed. LO 8 -2 Describe and evaluate different options firms have to organize economic 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 different diversification strategies. LO 8 -8 Explain when a diversification strategy creates a competitive advantage, and when it does not.

Vertical Integration along Industry Value Chain the • In what stages of the industry value chain should the firm participate? • Vertical integration Ø Ownership of its inputs, production, and outputs in the value chain Ø Horizontal value chain v Internal, firm-level value chains (Chapter 4) • Vertical value chain Ø Industry-level integration from upstream to downstream v Examples: cell phone industry value chain • Many different industries and firms

EXHIBIT 8. 4 Backward and Forward Vertical Integration along an Industry Value Chain

Types of Vertical Integration • Full vertical integration Ø Ex: Weyerhaeuser • Owns forests, mills, and distribution to retailers • Backward vertical integration Ø Ex: HTC’s backward integration into design of phones • Forward vertical integration Ø Ex: HTC’s forward integration into sales & branding • Not all industry value chain stages are equally profitable Ø Zara – primarily designs in-house & partners for speedy new fashions delivered to stores

EXHIBIT 8. 5 HTC’s Backward and Forward Integration along the Industry Value Chain in the Smartphone Industry

LO 8 -1 Define corporate-level strategy, and describe three dimensions along which it is assessed. LO 8 -2 Describe and evaluate different options firms have to organize economic 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 different diversification strategies. LO 8 -8 Explain when a diversification strategy creates a competitive advantage, and when it does not.

Benefits of Vertical Integration • Benefits of vertical integration Ø Market power • Entry barriers • Down-stream price maintenance • Up-stream power over prices Ø Securing critical supplies Ø Lowering costs (efficiency) Ø Improving quality Ø Facilitating scheduling and planning Ø Facilitating investments in specialized assets v Ex: HTC started as OEM & expanded to fully integrated

Benefits of Vertical Integration • Specialized assets Ø Assets that have significantly more value in their intended use than in their next best use • Types of specialized assets Ø Site specificity v Co-located such as coal plant and electric utility Ø Physical asset specificity v Bottling machinery Ø Human asset specificity v Mastering procedures of a particular organization

STRATEGY HIGHLIGHT 8. 2 Back to the Future: Pepsi. Co’s Forward Integration • Pepsi. Co acquired bottlers in 2009 Ø Gain control over quality, pricing, distribution, and in-store display. Reversed a 1999 decision to sell off Pepsi bottlers v Goal now is faster innovative products launched v • Forward integration Ø Enhance flexibility and improve decision making Ø Cost saving and interdependence • Coca-Cola did the same: forward integration with bottlers 1– 27

Risks of Vertical Integration • Increasing costs Ø Internal suppliers lose incentives to compete • Reducing quality Ø Single captured customer can slow experience effects • Reducing flexibility Ø Slow to respond to changes in technology or demand • Increasing the potential for legal repercussions Ø FTC carefully reviewed Pepsi plans to buy bottlers

Alternatives to Vertical Integration • Taper integration Ø Backward integrated but also relies on outside market firms for supplies OR Ø Forward integrated but also relies on outside market firms for some of its distribution • Strategic outsourcing Ø Moving value chain activities outside the firm's boundaries v Example: EDS and People. Soft provide HR services to many firms that choose to outsource it.

EXHIBIT 8. 6 Taper Integration along the Industry Value Chain Outside suppliers could also be off-shored when they are not located in the home country

Corporate Diversification: Expanding Beyond a Single Market • Degrees of diversification Ø Range of products and services a firm should offer v Ex: Pepsi. Co also owns Lay's & Quaker Oats. • Diversification strategies: Ø Product diversification v Active in several different product categories Ø Geographic diversification v Active in several different countries Ø Product – market diversification v Active in a range of both product and countries

EXHIBIT 8. 7 Different Types of Corporate Diversification

STRATEGY HIGHLIGHT 8. 3 Exxon. Mobil Diversifies into Natural Gas • Exxon. Mobil earned highest profit in its history in 2008 Ø Majority of profits come from petroleum-based products. • Environmental change toward clean energy Ø Exxon. Mobil must react to the change. Ø Exxon. Mobil to focus on clean energy: natural gas. • Exxon. Mobil acquired XTO Energy Ø Leverage core competence in exploration and commercialization of energy sources into natural gas. Ø 85% today fossil fuels v Exxon is largest producer of natural gas on the planet. Exxon XTO video 1– 34

LO 8 -1 Define corporate-level strategy, and describe three dimensions along which it is assessed. LO 8 -2 Describe and evaluate different options firms have to organize economic 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 different diversification strategies. LO 8 -8 Explain when a diversification strategy creates a competitive advantage, and when it does not.

Motivations For Diversification • Value Enhancing Motives: Ø Increase market power v Multi-point competition Ø R&D and new product development Ø Developing New Competencies (Stretching) Ø Transferring Core Competencies (Leveraging) v Utilizing excess capacity (e. g. , in distribution) v Economies of Scope v Leveraging Brand-Name (e. g. , Haagen-Dazs to chocolate candy)

Leveraging Core Competencies for Corporate Diversification • Core competence Ø Unique skills and strengths Ø Allows firms to increase the value of product/service Ø Lowers the cost • Examples: v Wal-mart – global supply chain v Infosys – low-cost global delivery system • The core competence – market matrix Ø Provides guidance to executives on how to diversify in order to achieve continued growth

EXHIBIT 8. 8 The Core Competence – Market Matrix Pepsi - Gatorade Bo. A - NCNB Salesforce. com Bo. A - Merrill Lynch

Other Motivations For Diversification • Motivations that are “Value neutral”: Ø Diversification motivated by poor economic performance in current businesses. • Motivations that “Devaluate”: Ø Agency problem Ø Managerial capitalism (“empire building”) Ø Maximize management compensation Ø Sales Growth maximization v Professor William Baumol

Diversification • Issue #1: When there is a reduction in managerial (employment) risk, then there is upside and downside effects for stockholders: Ø On the upside, managers will be more willing to learn firm-specific skills that will improve the productivity and long-run success of the company (to the benefit of stockholders). Ø On the downside, top-level managers may have the economic incentive to diversify to a point that is detrimental to stockholders.

Diversification • Issue #2: There may be no economic value to stockholders in diversification moves since stockholders are free to diversify by holding a portfolio of stocks. No one has shown that investors pay a premium for diversified firms -in fact, discounts are common. Ø A classic example is Kaiser Industries that was dissolved as a holding company because its diversification apparently subtracted from its economic value. v Kaiser Industries main assets: (1) Kaiser Steel; (2) Kaiser Aluminum; and (3) Kaiser Cement were independent companies 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.

Corporate Diversification • Diversification discount Ø Stock price of diversified firms is less • Diversification premium Ø Stock price of diversified firms is greater • Will diversification increase performance?

EXHIBIT 8. 9 The Diversification-Performance Relationship

EXHIBIT 8. 10 Vertical Integration and Diversification: Sources of Value Creation and Costs

EXHIBIT 8. 11 BCG Matrix

Corporate Diversification • Internal capital markets Ø Source of value creation in a diversification strategy Ø Allows conglomerate to do a more efficient job of allocating capital • Coordination cost Ø A function of number, size, and types of businesses linked to one another • Influence cost Ø Political maneuvering by managers to influence capital and resource allocation • Bandwagon effects Ø Firms copying moves of industry rivals

EXHIBIT 8. 12 Oracle Corporate Strategy: Combining Vertical Integration and Diversification

Sustainable Competitive Advantage • Trying to gain sustainable competitive advantage via mergers and acquisitions puts us right up against the “efficient market” wall: Ø If an industry is generally known to be highly profitable, there will be many firms bidding on the assets already in the market. Generally the discounted value of future cash flows will be impounded in the price that the acquirer pays. Thus, the acquirer is expected to make only a competitive rate of return on investment.

Sustainable Competitive Advantage • And the situation may actually be worse, given the phenomenon of the winner’s curse. Ø The most optimistic bidder usually over- estimates the true value of the firm: v Quaker Oats, in late 1994, purchased Snapple Beverage Company for $1. 7 billion. Many analysts calculated that Quaker Oats paid about $1 billion too much for Snapple. In 1997, Quaker Oats sold Snapple for $300 million.

Sustainable Competitive Advantage • Under what scenarios can the bidder do well? Ø Luck Ø Asymmetric Information – This eliminates the competitive bidding premise implicit in the “efficient market hypothesis” Ø Specific-synergies (co-specialized assets) between the bidder and the target. – Once again this eliminates the competitive bidding premise of the efficient market hypothesis.

Take-Away Concepts LO 8 -1 Define corporate-level strategy, and describe three dimensions along which it is assessed. ü While business strategy addresses “how to compete, ” corporate strategy addresses “where to compete. ü Corporate strategy concerns the scope of the firm along three dimensions: (1) vertical integration (along the industry value chain); (2) horizontal integration (diversification); and (3) geographic scope (global strategy). ü To gain & sustain competitive advantage, any corporate strategy must support and strengthen a firm’s strategic position regardless of whether it is a differentiation, cost leadership, or integration strategy.

Take-Away Concepts LO 8 -2 Describe and evaluate different options firms have to organize economic activity. ü Transaction cost economics help managers decide what activities to do in-house (“make”) versus what services and products to obtain from the external market (“buy”). ü When the costs to pursue an activity in-house are less than the costs of transacting in the market (Cin-house, Cmarket), then the firm should vertically integrate. ü In the resource-based view of the firm, a firm’s boundaries are delineated by its knowledge bases and competencies. ü 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 parent– subsidiary relationships.

Take-Away Concepts LO 8 -3 Describe two types of vertical integration along the industry value chain: backward and forward vertical integration. ü Vertical integration denotes a firm’s value added—what percentage of a firm’s sales is generated by the firm within its boundaries. ü Industry value chains (vertical value chains) depict the transformation of raw materials into finished goods and services. Each stage typically represents a distinct industry in which a number of different firms are competing. ü Backward vertical integration involves moving ownership of activities upstream nearer to the originating (inputs) point of the industry value chain. ü Forward vertical integration involves moving ownership of activities closer to the end (customer) point of the value chain.

Take-Away Concepts LO 8 -4 Identify and evaluate benefits and risks of vertical integration. ü Benefits of vertical integration include: securing critical supplies, lowering costs, improving quality, facilitating scheduling and planning, and facilitating investments in specialized assets. ü Risks of vertical integration include: increasing costs, reducing quality, reducing flexibility, and increasing the potential for legal repercussions. ü Vertical integration contributes to competitive advantage if the incremental value created is greater than the incremental costs of the specific corporate-level strategy. LO 8 -5 Describe and examine alternatives to vertical integration. ü Taper integration is a strategy in which a firm is backwardly integrated but also relies on outside market firms for some of its supplies, and/or is forwardly integrated but also relies on outside market firms for some if its distribution. ü Strategic outsourcing involves moving one or more value chain activities outside the firm’s boundaries to other firms in the industry value chain. Off-shoring is the outsourcing of activities outside the home country.

Take-Away Concepts LO 8 -6 Describe and evaluate different types of corporate diversification. ü A single-business firm derives 95 percent or more of its revenues from one business. ü A dominant-business firm derives between 70 and 95 percent of its revenues from a single business, but pursues at least one other business activity. ü A firm follows a related diversification strategy when it derives less than 70 percent of its revenues from a single business activity, but obtains revenues from other lines of business that are linked to the primary business activity. Choices within a related diversification strategy can be related-constrained or related-linked. ü 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 LO 8 -7 Apply the core competence–market matrix to derive different diversification strategies. ü When applying an existing/new dimension to core competencies and markets, four quadrants emerge, as depicted in Exhibit 8. 8. ü The lower-left quadrant combines existing core competencies with existing markets. Here, managers need to come up with ideas of how to leverage existing core competencies to improve their current market position. ü The lower-right quadrant combines existing core competencies with new market opportunities. Here, managers need to think about how to redeploy and recombine existing core competencies to compete in future markets. ü The upper-left quadrant combines new core competencies with existing market opportunities. Here, managers must come up with strategic initiatives of how to build new core competencies to protect and extend the firm’s current market position. ü The upper-right quadrant combines new core competencies with new market opportunities. This is likely the most challenging diversification strategy because it requires building new core competencies to create and compete in future markets.

Take-Away Concepts LO 8 -8 Explain when a diversification strategy creates a competitive advantage, and when it does not. ü The diversification-performance relationship is a function of the underlying type of diversification. ü The relationship between the type of diversification and overall firm performance takes on the shape of an inverted U (see Exhibit 8. 9). ü 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). The individual SBUs are evaluated according to relative market share and speed of market growth, and plotted into one of four categories (dog, cash cow, star, and question mark). Each category warrants a different investment strategy. ü Both low levels and high levels of diversification are generally associated with lower overall performance, while moderate levels of diversification are associated with higher firm performance.