corporate strategy: vertical integration and diversification joe mahoney
TRANSCRIPT
Corporate Strategy: Vertical Integration and
Diversification
Joe Mahoney
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 initiatives at General Electric (GE) in clean-tech
and health care industries
• Corporate strategy concerns the scope of the firm
Industry value chain
Products and services
Geography
8–2
Three Dimensions of Corporate Strategy
Scope of the firm determines boundaries along these 3 dimensions.
8–3
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 and training employees
8–4
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
8–5
Organizing Economic Activity: Firm vs. Markets
8–6
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
Alternatives along the Make or Buy Continuum
8–8
Backward and Forward Vertical Integration along an Industry Value Chain
8–9
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
8–10
HTC’s Backward and Forward Integration along the Industry Value Chain in the Smartphone Industry
8–11
Vertical IntegrationVertical IntegrationProfessor Oliver Williamson of University of California at Berkeley has made clear that In order to avoid confusion on the vertical coordination problem it is important for the manager to separate two distinct issues:
Issue #1: What is the objective for vertical coordination? Or put differently, what efficiencies, risk sharing, or market power advantages are being sought?
Issue #2: What organizational form (e.g., vertical contracts, equity joint ventures, mergers & acquisitions) best achieves the desired objective(s)?
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 and expanded to fully integrated
8–13
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
8–14
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
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
8–16
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.
8–17
Taper Integration along the Industry Value Chain
Outside suppliers couldalso be off-shored when they are not located in thehome country
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
8–19
Corporate Diversification: Expanding Beyond a Single Market
• Degrees of diversification Range of products and services a firm offers
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
8–20
Different Types of Corporate Diversification
8–21
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)
8–22
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: 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
8–23
The Core Competence – Market Matrix
BoA - NCNB BoA - Merrill Lynch
Pepsi - Gatorade Salesforce.com
8–24
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.
8–27
The Diversification-Performance Relationship
Vertical Integration and Diversification: Sources of Value Creation and Costs
8–29
BCG Matrix
8–30
Knowledge Creation
• Research
KnowledgeAcquisition
KnowledgeGeneration
(“Exploration”)
• Training• Recruitment• Intellectual property
licensing• Benchmarking
KnowledgeApplication
(“Exploitation”)
KnowledgeIntegration
• New product development
• Operations
KnowledgeSharing
• Strategic planning• Communities of practice
Knowledge Storage &
Organization
Knowledge Replication
• Best practices transfer• On-the-job training
• Databases• Standard operating practices
Knowledge Measurement
• Intellectual capital accounting• Competency modeling
KnowledgeIdentification
• Project reviews• Competency modeling
Knowledge Processes within the Organization
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
8–32
Oracle Corporate Strategy: Combining Vertical Integration and Diversification
8–33
Ch7-3
Problems inAchieving Success
Problems inProblems inAchieving SuccessAchieving Success
IntegrationIntegrationdifficultiesdifficulties
Inadequate Inadequate evaluation of targetevaluation of target
Too muchToo muchdiversificationdiversification
Large orLarge orextraordinary debtextraordinary debt
Inability toInability toachieve synergyachieve synergy
Managers overlyManagers overlyfocused on acquisitionsfocused on acquisitions
Too largeToo large
IncreasedIncreasedmarket powermarket power
OvercomeOvercomeentry barriersentry barriers
Lower riskLower riskcompared to developing compared to developing
new productsnew products
Cost of newCost of newproduct developmentproduct development
Increased speedIncreased speedto marketto market
IncreasedIncreaseddiversificationdiversification
Avoid excessiveAvoid excessivecompetitioncompetition
AcquisitionsAcquisitions
Reasons forReasons forAcquisitions Acquisitions
20
Attributes of Effective Attributes of Effective AcquisitionsAcquisitions
AttributesAttributes ResultsResults
Complementary Complementary Assets or ResourcesAssets or Resources
Buying firms with assets that meet current Buying firms with assets that meet current needs to build competitivenessneeds to build competitiveness
Friendly Friendly AcquisitionsAcquisitions
Friendly deals make integration go more Friendly deals make integration go more smoothlysmoothly
Careful Selection Careful Selection ProcessProcess
Deliberate evaluation and negotiations are Deliberate evaluation and negotiations are more likely to lead to easy integration and more likely to lead to easy integration and building synergiesbuilding synergies
Maintain Financial Maintain Financial SlackSlack
Provide enough additional financial Provide enough additional financial resources so that profitable projects would resources so that profitable projects would not be foregonenot be foregone
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.
8–36
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.