1. Corporate Strategy: Vertical Integration and Diversification

2. Part 2 Strategy Formulation

3. 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.

4. 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

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

6. 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.

7. 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

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

9. 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.

10. 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

11. 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)

12. 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.

13. 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 

14. 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.

15. 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.
1–15
China Rare Earth Video 15

16. 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.

17. 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.

18. 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

19. 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.

20. 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.

22. 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

23. 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

25. 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

26. 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

27. 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.

28. 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

30. 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

31. Different Types of Corporate Diversification
EXHIBIT 8.7

32. 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.
1–32
Exxon XTO video 32

33. 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.

34. 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)

35. 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

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

37. 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

38. 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.

39. 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.

40. 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.

41. 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.

42. BCG Matrix
EXHIBIT 8.11

44. 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

45. Oracle Corporate Strategy: Combining
Vertical Integration and Diversification
EXHIBIT 8.12

48. 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.

49. 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.

50. 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.