8

CHAPTER
McGraw-Hill/I rwin
Copyright 2013 by The McGraw-Hill Companies, I nc. All rights reserved.
Corporate Strategy:
Vertical Integration
and Diversification
Part 2 Strategy Formulation
82
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.
83
Chapter Case 8
Refocusing GE: A Future of
Clean-Tech and Health Care?
Jeffrey Immelt appointed CEO of GE Sept. 7
th
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

84
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.

86
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
87
EXHIBIT 8.1 Three Dimensions of Corporate Strategy
Scope of the firm determines boundaries along these 3 dimensions.
88
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.
89
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

810
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)
811
EXHIBIT 8.2
Organizing Economic Activity: Firm vs. Markets
812
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
814
115
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
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.
816
EXHIBIT 8.4
Backward and Forward Vertical Integration
along an Industry Value Chain
817
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


818
EXHIBIT 8.5
HTCs Backward and Forward Integration along the
Industry Value Chain in the Smartphone Industry
819
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.
820
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
822
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
823
Managerial Eco. - Rutgers University 6-13
Optimal Input Procurement
Substantial
specialized
investments
relative to
contracting costs?
Spot Exchange
No
Complex contracting
environment relative to
costs of integration?
Yes
Vertical
Integration
Yes
Contract
No
125
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

825
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
826
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.

827
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
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
829
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
830
EXHIBIT 8.7 Different Types of Corporate Diversification
831
132
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 832
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.
833
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)
834
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

835
EXHIBIT 8.8
The Core Competence Market Matrix
BoA - NCNB BoA - Merrill Lynch
Pepsi - Gatorade Salesforce.com
836
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.

839
EXHIBIT 8.9
The Diversification-Performance Relationship
EXHIBIT 8.10
Vertical Integration and Diversification:
Sources of Value Creation and Costs
841
EXHIBIT 8.11
BCG Matrix
842
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

844
EXHIBIT 8.12
Oracle Corporate Strategy: Combining
Vertical Integration and Diversification
845
Ch7-3
Problems in
Achieving Success
Problems in Problems in
Achieving Success Achieving Success
Integration Integration
difficulties difficulties
Inadequate Inadequate
evaluation of target evaluation of target
Too much Too much
diversification diversification
Large or Large or
extraordinary debt extraordinary debt
Inability to Inability to
achieve synergy achieve synergy
Managers overly Managers overly
focused on acquisitions focused on acquisitions
Too large Too large
Increased Increased
market power market power
Overcome Overcome
entry barriers entry barriers
Lower risk Lower risk
compared to developing compared to developing
new products new products
Cost of new Cost of new
product development product development
Increased speed Increased speed
to market to market
Increased Increased
diversification diversification
Avoid excessive Avoid excessive
competition competition
Acquisitions Acquisitions
Reasons for Reasons for
Acquisitions Acquisitions
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.
848
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.