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.

Refocusing GE: A Future of Clean-Tech and Health Care? Chapter Case 8 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

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

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

What Is 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

Three Dimensions of Corporate Strategy EXHIBIT 8.1 Scope of the firm determines boundaries along these 3 dimensions.

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.

Transaction Cost Economics and Scope of the Firm 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 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)

Organizing Economic Activity: Firm vs. Markets EXHIBIT 8.2 Organizing Economic Activity: Firm vs. Markets INSTRUCTOR: An Interactive video activity is available online through McGraw-Hill Connect on this section of the text. It covers Learning Objective 8.2.

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 EXHIBIT 8.3 Alternatives along the Make or Buy Continuum INSTRUCTOR: An Interactive video activity is available online through McGraw-Hill Connect on this section of the text. It covers Learning Objective 8.2.

Toyota Locks Up Lithium for Car Batteries 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 INSTRUCTOR: A 6-minute video on China’s vital role in the supply of global rare earth metals. In fall of 2010, China restricted exports of the materials. The video was produced by The New York Times in November 2010. 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 1–15 China Rare Earth Video 15

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.

Backward and Forward Vertical Integration along an Industry Value Chain EXHIBIT 8.4 INSTRUCTOR: An Interactive activity is available online through McGraw-Hill Connect on this section of the text. It covers Learning Objective 8.3 & 8.4 on types and advantages of vertical integration.

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

HTC’s Backward and Forward Integration along the Industry Value Chain in the Smartphone Industry EXHIBIT 8.5 INSTRUCTOR: An Interactive activity is available online through McGraw-Hill Connect on this section of the text. It covers Learning Objective 8.3 & 8.4 on types and advantages of vertical integration.

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.

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

Back to the Future: PepsiCo’s Forward Integration 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 INSTRUCTOR: The textbook DVD has an eight-minute audio clip from The Economist on Pepsi’s diversification of foods and the integration of its bottlers. 1–25 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

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.

Taper Integration along the Industry Value Chain 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 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

Different Types of Corporate Diversification EXHIBIT 8.7

ExxonMobil Diversifies into Natural Gas STRATEGY HIGHLIGHT 8.3 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. INSTRUCTOR: A 90-second video on Exxon’s purchase of XTO Energy. The video was produced by The New York Times in December 2009. 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 1–32 Exxon XTO video 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.

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

The Core Competence – Market Matrix EXHIBIT 8.8 The Core Competence – Market Matrix Pepsi - Gatorade Salesforce.com BoA - NCNB BoA - Merrill Lynch

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.

The Diversification-Performance Relationship EXHIBIT 8.9 The Diversification-Performance Relationship INSTRUCTOR: An Interactive activity is available online through McGraw-Hill Connect on this section of the text. It covers Learning Objective 8.8 on the appropriate context of diversification for competitive advantage.

Vertical Integration and Diversification: Sources of Value Creation and Costs EXHIBIT 8.10 INSTRUCTOR: An Interactive activity is available online through McGraw-Hill Connect on this section of the text. It covers Learning Objective 8.8 on the appropriate context of diversification for competitive advantage.

BCG Matrix EXHIBIT 8.11

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

Oracle Corporate Strategy: Combining Vertical Integration and Diversification EXHIBIT 8.12

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.

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.