CHAPTER

Corporate Strategy: Vertical Integration and Diversification

McGraw-Hill/Irwin

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

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) GEs 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 cellsetc. Healthymagination: increase quality and access to health care

Chapter Case 8

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

GEs Changing Product Scope

Chapter Case 8

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

GEs Changing Geographic Scope

Source: Authors 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 Immelts 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.

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 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

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

China Rare Earth Video

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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.

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: HTCs backward integration into design of phones

Forward vertical integration

Ex: HTCs 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

HTCs Backward and Forward Integration along the Industry Value Chain in the Smartphone Industry

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

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 Bottling machinery Mastering procedures of a particular organization

Physical asset specificity

Human asset specificity

Optimal Input Procurement

No
Substantial specialized investments relative to contracting costs?

Spot Exchange

Yes

Complex contracting environment relative to costs of integration?

No Contract
Managerial Eco. - Rutgers University

Yes
Vertical Integration
6-13

STRATEGY HIGHLIGHT 8.2

Back to the Future: PepsiCos 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

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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 could also be off-shored when they are not located in the home country

Risks in undertaking cooperative agreements or strategic alliances

Adverse selection

Partners misrepresent skills, ability and other resources Partners provide lower quality skills and abilities than they had promised Partners exploit the transaction specific investment made by others in the alliance

Moral Hazard

Holdup

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 Active in several different countries Active in a range of both product and countries

Geographic diversification Product market diversification

EXHIBIT 8.7

Different Types of Corporate Diversification

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

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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:
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

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.

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 8.9

The Diversification-Performance Relationship

EXHIBIT 8.10

Vertical Integration and Diversification: Sources of Value Creation and Costs

EXHIBIT 8.11

BCG Matrix

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 8.12

Oracle Corporate Strategy: Combining Vertical Integration and Diversification

Reasons for Acquisitions

Increased market power Overcome entry barriers Cost of new product development Increased speed to market Lower risk compared to developing new products Increased diversification Avoid excessive competition

Problems in Achieving Success

Integration difficulties Inadequate evaluation of target Large or extraordinary debt

Acquisitions

Inability to achieve synergy Too much diversification Managers overly focused on acquisitions 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.

Sustainable Competitive Advantage

And the situation may actually be worse, given the phenomenon of the winners 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.

Take-Away Concepts
LO 8-1 Define corporate-level strategy, and describe the three dimensions along which it is assessed. 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 firms strategic position regardless of whether it is a differentiation, cost leadership, or integration strategy.

Take-Away Concepts
LO 8-2 Describe and evaluate different options firms have to organize economic activity. 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 firms 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
LO 8-3 Describe two types of vertical integration along the industry value chain: backward and forward vertical integration. Vertical integration denotes a firms value addedwhat percentage of a firms 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
LO 8-4 Identify and evaluate benefits and risks of vertical integration. 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. LO 8-5 Describe and examine alternatives to vertical integration. 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 firms boundaries to other firms in the industry value chain. Off-shoring is the outsourcing of activities outside the home country.

Take-Away Concepts
LO 8-6 Describe and evaluate different types of corporate diversification. 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 competencemarket 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 firms 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
LO 8-8 Explain when a diversification strategy creates a competitive advantage, and when it does not. 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.