Corporate Strategy: Vertical Integration and Diversification

8CHAPTER

McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

Corporate Strategy: Vertical Integration and Diversification

Part 2 Strategy Formulation

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.

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

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 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

What Is Corporate Strategy?

• Three key dimensions:

What stages of industry value chain and degrees of vertical integration

What range of products and services and degrees of horizontal integration and diversification

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.

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

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)

EXHIBIT 8.2 Organizing Economic Activity: Firm vs. Markets

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

1–16

STRATEGY HIGHLIGHT 8.1STRATEGY 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

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=cse

Vertical Integration along the Industry Value Chain

• In what stages of the industry value chain should the firm participate?

• Vertical integration Ownership of its inputs, production, and

outputs in the value chain Horizontal value chain

Internal, firm-level value chains (Chapter 4)

• Vertical value chain Industry-level integration from upstream to

downstream 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 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

EXHIBIT 8.5 HTC’s Backward and Forward Integration along the Industry Value Chain in the Smartphone Industry

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 & expanded to fully integrated

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

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

1–27

STRATEGY HIGHLIGHT 8.2STRATEGY 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

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

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.

EXHIBIT 8.6 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

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

EXHIBIT 8.7 Different Types of Corporate Diversification

1–34

STRATEGY HIGHLIGHT 8.3STRATEGY 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

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=cse

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)

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

EXHIBIT 8.8 The Core Competence – Market Matrix

BoA - NCNB BoA - Merrill Lynch

Pepsi - Gatorade Salesforce.com

http://www.salesforce.com/

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.

Corporate Diversification

• Diversification discount Stock price of diversified firms is less

• Diversification premium Stock price of diversified firms is greater

• Will diversification increase performance?

EXHIBIT 8.9The Diversification-Performance Relationship

EXHIBIT 8.10Vertical Integration and

Diversification: Sources of Value Creation and Costs

EXHIBIT 8.11 BCG Matrix

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

EXHIBIT 8.12Oracle Corporate Strategy:

Combining Vertical Integration and

Diversification

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.


• 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.


• 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.


While business strategy addresses “how to compete,” corporate strategy addresses “where to compete.

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).

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


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”).

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.

In the resource-based view of the firm, a firm’s boundaries are delineated by its knowledge bases and competencies.

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


Vertical integration denotes a firm’s value added—what percentage of a firm’s sales is generated by the firm within its boundaries .

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 .

Backward vertical integration involves moving ownership of activities upstream nearer to the originating (inputs) point of the industry value chain .

Forward vertical integration involves moving ownership of activities closer to the end (customer) point of the value chain.

Take-Away Concepts


Benefits of vertical integration include: securing critical supplies, lowering costs, improving quality, facilitating scheduling and planning, and facilitating investments in specialized assets.

Risks of vertical integration include: increasing costs, reducing quality, reducing flexibility, and increasing the potential for legal repercussions.

Vertical integration contributes to competitive advantage if the incremental value created is greater than the incremental costs of the specific corporate-level strategy.


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.

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


A single-business firm derives 95 percent or more of its revenues from one business.

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.

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.

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.

When applying an existing/new dimension to core competencies and markets, four quadrants emerge, as depicted in Exhibit 8.8.

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.

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.

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 .

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

Take-Away Concepts


The diversification-performance relationship is a function of the underlying type of diversification.

The relationship between the type of diversification and overall firm performance takes on the shape of an inverted U (see Exhibit 8.9).

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.

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.

Corporate Strategy: Vertical Integration and Diversification

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