CHAPTER Corporate Strategy: Vertical Integration and Diversification McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc.
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Transcript CHAPTER Corporate Strategy: Vertical Integration and Diversification McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc.
CHAPTER
8
Corporate Strategy:
Vertical Integration
and Diversification
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Part 2 Strategy Formulation
8–2
LO 8-1 Define corporate-level strategy, and describe the 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.
8–3
Chapter Case 8
Refocusing GE: A Future of
Clean-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 cells…etc.
• “Healthymagination”: increase quality and access to health care
8–4
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.
8–6
What Is Corporate Strategy?
• Corporate strategy
Corporate strategy is the way a company creates value through the
configuration and coordination of its multi-market activities
Quest 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 chain
Products and services
Geography
8–7
EXHIBIT 8.1
Three Dimensions of Corporate Strategy
Scope of the firm determines boundaries along these 3 dimensions.
8–8
LO 8-1 Define corporate-level strategy, and describe the 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.
8–9
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 costs
Costs pertaining to organizing an exchange within a
hierarchy
Ex: recruiting & training employees
8–10
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
Ex: Microsoft hires programmers to write code
in-house rather than contracting out
Firms and markets have distinct advantages and
disadvantages (see Exhibit 8.2)
8–11
EXHIBIT 8.2
Organizing Economic Activity: Firm vs. Markets
8–12
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
Akerlof – “Lemons problem” for used cars
– Receiving Noble prize in Economics
EXHIBIT 8.3
Alternatives along the Make or Buy Continuum
8–14
STRATEGY HIGHLIGHT 8.1
Toyota Locks Up Lithium
for 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 to
power 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
1–15
China Rare Earth Video
LO 8-1 Define corporate-level strategy, and describe the 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.
8–16
EXHIBIT 8.4
Backward and Forward Vertical Integration
along an Industry Value Chain
8–17
Types of Vertical Integration
• Full vertical integration
Ex: Weyerhaeuser
• Owns forests, mills, and distribution to retailers
• Backward vertical integration
Ex: HTC’s backward integration into design of phones
• Forward vertical integration
Ex: HTC’s forward integration into sales & branding
• Not all industry value chain stages are equally
profitable
Zara – primarily designs in-house & partners for speedy
new fashions delivered to stores
8–18
EXHIBIT 8.5
HTC’s Backward and Forward Integration along the
Industry Value Chain in the Smartphone Industry
8–19
LO 8-1 Define corporate-level strategy, and describe the 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.
8–20
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
8–22
Benefits of Vertical Integration
• Specialized assets
Assets that have significantly more value in their
intended use than in their next best use
• Types of specialized assets
Site specificity
Co-located such as coal plant and
electric utility
Physical asset specificity
Bottling machinery
Human asset specificity
Mastering procedures of a particular organization
8–23
Optimal Input Procurement
No
Substantial
specialized
investments
relative to
contracting costs?
Yes
No
Contract
Managerial Eco. - Rutgers University
Spot Exchange
Complex contracting
environment relative to
costs of integration?
Yes
Vertical
Integration
6-13
STRATEGY HIGHLIGHT 8.2
Back to the Future:
PepsiCo’s Forward Integration
• PepsiCo acquired bottlers in 2009
Gain 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
1–25
8–25
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
8–26
Alternatives to Vertical Integration
• Taper integration
Backward integrated but also relies on outside market firms
for supplies
OR
Forward integrated but also relies on outside market firms
for some of its distribution
• Strategic outsourcing
Moving value chain activities outside the firm's boundaries
Example: EDS and PeopleSoft provide HR services to
many firms that choose to outsource it.
8–27
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
Risks in undertaking cooperative
agreements or strategic alliances
Adverse selection
Moral Hazard
Partners misrepresent skills, ability and other
resources
Partners provide lower quality skills and
abilities than they had promised
Holdup
Partners exploit the transaction specific
investment made by others in the alliance
8–29
Corporate Diversification:
Expanding Beyond a Single Market
• Degrees of diversification
Range 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 categories
Geographic diversification
Active in several different countries
Product – market diversification
Active in a range of both product and countries
8–30
EXHIBIT 8.7
Different Types of Corporate Diversification
8–31
STRATEGY HIGHLIGHT 8.3
ExxonMobil Diversifies into
Natural 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
1–32
8–32
LO 8-1 Define corporate-level strategy, and describe the 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.
8–33
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 Scope
Leveraging Brand-Name
(e.g., Haagen-Dazs to chocolate candy)
8–34
Leveraging Core Competencies for
Corporate Diversification
• Core competence
Unique skills and strengths
Allows firms to increase the value of product/service
Lowers the cost
• Examples:
– global supply chain
Infosys – low-cost global delivery system
Wal-mart
• The core competence – market matrix
Provides guidance to executives on how to diversify
in order to achieve continued growth
8–35
EXHIBIT 8.8
The Core Competence – Market Matrix
Pepsi - Gatorade
BoA - NCNB
Salesforce.com
BoA - Merrill Lynch
8–36
Other Motivations For Diversification
• Motivations that are “Value neutral”:
Diversification motivated by poor economic performance
in current businesses.
• Motivations that “Devaluate”:
Agency problem
Managerial capitalism (“empire building”)
Maximize management compensation
Sales Growth maximization
Professor William Baumol
Diversification
• Issue #1: When there is a reduction in managerial
(employment) risk, then there is upside and
downside effects for stockholders:
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).
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.
A classic example is Kaiser Industries that was dissolved
as a holding company because its diversification
apparently subtracted from its economic value.
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.
8–39
EXHIBIT 8.9
The Diversification-Performance Relationship
EXHIBIT 8.10
Vertical Integration and Diversification:
Sources of Value Creation and Costs
8–41
EXHIBIT 8.11
BCG Matrix
8–42
Corporate Diversification
• Internal capital markets
Source of value creation in a diversification strategy
Allows conglomerate to do a more efficient job of
allocating capital
• Coordination cost
A function of number, size, and types of businesses
linked to one another
• Influence cost
Political maneuvering by managers to influence
capital and resource allocation
• Bandwagon effects
Firms copying moves of industry rivals
8–44
EXHIBIT 8.12
Oracle Corporate Strategy: Combining
Vertical Integration and Diversification
8–45
Problems in
Achieving Success
Reasons for
Acquisitions
Increased
market power
Integration
difficulties
Overcome
entry barriers
Inadequate
evaluation of target
Cost of new
product development
Large or
extraordinary debt
Increased speed
to market
Acquisitions
Inability to
achieve synergy
Lower risk
compared to developing
new products
Too much
diversification
Increased
diversification
Managers overly
focused on acquisitions
Avoid excessive
competition
Too large
Ch7-3
Sustainable Competitive Advantage
• Trying to gain sustainable competitive advantage via
mergers and acquisitions puts us right up against the
“efficient market” wall:
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.
8–48
Sustainable Competitive Advantage
• And the situation may actually be
worse, given the phenomenon of the
winner’s curse.
The most optimistic bidder usually over-
estimates the true value of the firm:
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?
Luck
Asymmetric Information
– This eliminates the competitive bidding premise
implicit in the “efficient market hypothesis”
Specific-synergies (co-specialized assets) between
the bidder and the target.
– Once again this eliminates the competitive
bidding premise of the efficient market
hypothesis.