CHAPTER 6 - Corporate Level Strategy: Creating Value through Diversification

Corporate-level strategy

A strategy that focuses on gaining long-term revenue, profits, and market

value through managing operations in multiple businesses. Determining how to create
value through entering new markets, introducing new products, or developing new
technologies is a vital issue in strategic management, but maintaining a focus on
“creating value” is essential to long-term success.

Making Diversification Work Diversification

The process of firms expanding their operations by entering new businesses.

Diversification initiatives must create value for shareholders through:
 Mergers and Acquisitions
 Strategic Alliances
 Joint Ventures
 Internal Development
 Diversification should create synergy.
Business 1 + Business 2 = More than two
A Synergy, which means “working together”, and synergistic effects should be
multiplicative – one plus one should equal more than two.
 A firm may diversify into related businesses.
Related businesses- are those that share resources.
Benefits derive from horizontal relationships.
1. Sharing intangible resources such as core competencies in marketing.
2. Sharing tangible resources such as production facilities.
 A firm may diversify into unrelated businesses.
Unrelated businesses- have few similarities in products or industries, however the
corporate office can add value through such activities as robust information systems
or superb human resource practices.

Benefits derive from hierarchical relationships.

1. Value creation derived from the corporate office.
2. Leveraging support activities in the value chain.

Benefits derived from horizontal (related diversification) and hierarchical

(unrelated diversification) relationships are not mutually exclusive. Many firms that
diversify into related areas benefit from information technology expertise in the
corporate office. Similarly, unrelated diversifiers often benefit from the “best practices”
of sister businesses even though their products, markets, and technologies may differ
dramatically. An example would be a corporate parent with strong support activities in
the value chain such as information systems or human resource practices.
Related Diversification

A firm entering a different business in which it can benefit from leveraging core
competencies, sharing activities, or building market power.
 Related diversification enables a firm to benefit from horizontal relationships
across different businesses.
Economies of scope

Cost savings from leveraging core competencies or sharing related activities among
businesses in a corporation.
Economies of scope allow businesses to:
 Leverage core competencies
 Share related activities
 Enjoy greater revenues

A firm can also enjoy greater revenues if two businesses attain higher levels of sales
growth combined than either company could attain independently (this is the
synergistic effect).
Market Power

Firms’ abilities to profit through restricting or controlling supply to a market or

coordinating with other firms to reduce investment
Related businesses gain market power by:
 Pooled negotiating power
 Vertical integration

Related Diversification: Leveraging Core Competencies

 Core competencies reflect the collective learning in organizations.

 Can lead to the creation of value and synergy
 They create superior customer value
 The value chain elements in separate businesses require similar skills.

Core competencies

A firm’s strategic resources that reflect the collective learning in the

organization. This collective learning includes how to coordinate diverse production
skills, integrate multiple streams of technologies, and market diverse products and
services. Core competencies are the glue that binds existing businesses together,
achieved by transferring accumulated skills and expertise across business units in a
corporation. Core competencies can lead to the creation of value and synergy, but
these core competencies must enhance competitive advantage(s) by creating
superior customer value – by building on existing skills and innovations in a way that
appeals to customers, as at Apple. Different businesses in the firm must also be
similar in at least one important way related to the core competence. It’s not essential
that products or services themselves be similar, it is essential that one or more
elements in the value chain require similar essential skills – IBM’s computing power is
an example. Finally, core competencies must be difficult for competitors to imitate or
find substitutes for. Specialized technical skills acquired during a company’s work
experience, such as at Amazon, are an example.

Related Diversification: Sharing Activities

Sharing Activities

Having activities of two or more businesses’ value chains done by one of the
businesses.
 Corporations can also achieve synergy by sharing activities across their business
units.
 Sharing tangible & value-creating activities can provide payoffs;
 Cost savings through elimination of jobs, facilities, & related expenses, or
economies of scale
 Revenue enhancements through increased differentiation & sales growth.

Tangible value-creating activities can include common manufacturing facilities,

distribution channels, and sales forces. Cost savings are generally highest when one
company acquires another from the same industry in the same country. Sharing
activities inevitably involve costs that the benefits must outweigh such as the greater
coordination required to manage a shared activity. Sharing activities can also
increase the effectiveness of differentiation strategies. For instance, a shared order-
processing system may permit new features and services that a buyer will value.

Related Diversification: Market Power

Market power
Firms’ abilities to profit through restricting or controlling supply to a market or
coordinating with other firms to reduce investment.
 Market power can lead to the creation of value and synergy through
 Pooled negotiating power is the improvement in bargaining position relative to
suppliers and customers.
 Gaining greater bargaining power with suppliers & customers
Similar businesses working together or the affiliation of the business with a strong
parent can strengthen an organization’s purchasing clout. However, managers must
carefully evaluate how the combined businesses may affect relationships with actual
and potential customers, suppliers, and competitors – they may retaliate.

Vertical integration- becoming its own supplier or distributor through

 Backward Integration
 Forward Integration

Vertical integration

An expansion or extension of the firm by integrating preceding or successive

production processes. Vertical integration occurs when a firm becomes its own
supplier or distributor. The firm can incorporate more processes toward the original
source of raw materials (backward integration) or toward the ultimate consumer
(forward integration).

Related Diversification: Vertical Integration

Exhibit 6.3 Simplified Stages of Vertical Integration: Shaw Industries

Vertical integration can be a viable strategy for many firms. Shaw Industries is a
carpet maker that has attained a dominant position in the industry via a strategy of
vertical integration. Shaw has successfully implemented strategies of both forward
AND backward integration.
In making vertical integration decisions, five issues should be considered.

1. Is it the company satisfied with the quality of the value that its present suppliers
and distributors are providing?

2. Are there activities in the industry value chain presently being outsourced or
performed independently by others that are viable source of future profits?

3. Is there a high level of stability in the demand for the organization’s products?

4. Does the company have the necessary competencies to execute the vertical
integration strategies?

5. Will the vertical integration initiatives have potential negative impacts on the firm’s
stakeholders?
If the performance of organizations in the vertical chain is satisfactory, it may
not, in general, be appropriate for a company to perform these activities itself.
However, even if a firm IS outsourcing value chain activities to companies that are
doing a credible job, it may be missing out on substantial profit opportunities. Note:
high demand or sales volatility are not that conducive to vertical integration. With a
high level of fixed costs in plant and equipment as well as operating costs that
accompany endeavors toward vertical integration, widely fluctuating sales demand
can either strain resources (in times of high demand) or result in unused capacity (in
times of low demand). Finally, successfully executing strategies of vertical integration
can be very difficult and can require significant competencies. In addition, managers
must carefully consider the impact that vertical integration may have on existing and
future customers, suppliers, and competitors
The transaction cost perspective
A perspective that the choice of a transaction’s governance structure, such as
vertical integration or market transaction, is influenced by transaction costs, including
search, negotiating, contracting, monitoring, and enforcement costs, associated with
each choice.

Every market transaction involves some transaction costs:

 Search costs
 Negotiating costs
 Contract costs
 Monitoring costs
 Enforcement costs
 Need for transaction specific investments
 Administrative costs

Transaction costs are the sum of the above costs. These transaction costs
can be avoided by internalizing the activity in other words, by producing the input in-
house. However, vertical integration gives rise to administrative costs as well.
Coordinating different stages of the value chain now internalized within the
firm causes administrative costs to go up. Decisions about vertical integration are,
therefore, based on a comparison of transaction costs and administrative costs. If
transaction costs are lower than administrative costs, it is best to resort to market
transactions and avoid vertical integration. On the other hand, if transaction costs are
higher than administrative costs, vertical integration becomes an attractive strategy.

Unrelated Diversification

A firm entering a different business that has little horizontal interaction with other
businesses of a firm.
 Unrelated diversification enables a firm to benefit from vertical or hierarchical
relationships between the corporate office & individual business units through.

Benefits of unrelated diversification come from the vertical or hierarchical

relationships, or creation of synergies from the interaction of the corporate office with
the individual business units. The corporate office can contribute to parenting and
restructuring of often acquired businesses or can add value by viewing the entire
corporation as a family or portfolio of businesses and allocating resources to optimize
corporate goals of profitability, cash flow, and growth.
Parenting advantage

The positive contributions of the corporate office to a new business as a result of

expertise and support provided, and not as a result of substantial changes in assets,
capital structure, or management.
 The corporation parenting advantage
 Providing competent central functions
Restructuring

The intervention of the corporate office in a new business that substantially changes
the assets, capital structure, and/or management, including selling off parts of the
business, changing the management, reducing payroll and unnecessary sources of
expenses, changing strategies, and infusing the new business with new technologies,
processes, and reward systems.
 Restructuring to redistribute assets
 Asset, capital, & management restructuring
Portfolio management - A method and of assessing the competitive position of a
portfolio of businesses within a corporation, suggesting strategic alternatives for each
business, and identifying priorities for the allocation of resources across the
businesses.

Unrelated Diversification: Parenting & Restructuring

 Parenting allows the corporate office create value through management expertise
& competent central functions.
 In restructuring the parent intervenes:
 Asset restructuring involves the sale of unproductive assets.
 Capital restructuring involves changing the debt-equity mix, adding debt or equity
 Management restructuring involves changes in the top management team,
organizational structure, & reporting relationships.

Parenting relates to the positive contributions of the corporate office to a new

business as a result of expertise and support provided in areas such as legal,
financial, human resource management, procurement, and the like. Corporate
parents also help subsidiaries make wise choices in their own acquisitions,
divestitures, and new internal development decisions. With a restructuring strategy
the corporate office tries to find either poorly performing firms with unrealized
potential or firms in industries on the threshold of some significant, positive change.
The parent intervenes, often selling off parts of the business; changing theSuggesting
strategic alternatives for each business management; reducing payroll and
unnecessary sources of expenses; changing strategies; and infusing the company
with new technologies, processes, reward systems, and so forth. When the
restructuring is complete, the firm can either “sell high” and capture the added value
or keep the business and enjoy financial and competitive benefits. In order for this to
work, the corporate parent must have the requisite skills and resources to turn the
businesses around, even if they may be in new and unfamiliar industries.

Unrelated Diversification: Portfolio Management

Portfolio management involves a better understanding of the competitive position of

an overall portfolio or family of businesses by…

 Suggesting strategic alternatives for each business

 Identifying priorities for the allocation of resources
 Using Boston consulting group’s (BCG) growth/share matrix
Unrelated Diversification: Portfolio Management
Exhibit 6.5 The Boston Consulting Group (BCG) Portfolio Matrix

Each circle represents one of the firm’s business units. The size of the circle
represents the relative size of the business unit in terms of revenue.

In the BCG approach, each of the firm’s strategic business units (SBUs) is plotted on
a two-dimensional grid in which the axes are relative market share and industry
growth rate. Relative market share is measured by the ratio of the business units’ size
to that of its largest competitor. Growth rate is estimated from market data. The four
quadrants of the grid include stars: firms with long-term growth potential that should
continue to receive substantial investment funding; question marks: SBUs operating
in high-growth industries with relatively weak market shares where resources should
be invested in them to enhance their competitive positions; cash cows: SBUs with
high market shares in low-growth industries that have limited long-run potential but
represent a source of current cash flows to fund investments in “stars” and “question
marks”; dogs: SBUs with weak positions and limited potential - most analysts
recommend that they be divested.

Unrelated Diversification: Portfolio Management

Limitations of portfolio models:

 SBUS are compared on only two dimensions & each sbu is considered a
standalone entity
1. Are these the nly factors that really matter?
2. Can every unit be accurately compared on that basis? what about possible
 synergies?

 An oversimplified graphical model substitutes for managers’ experience

 Following strict & simplistic rules for resource allocation can be detrimental to a
firm’s long-term viability

Limitations of portfolio models: comparing SBUs on only two dimensions, viewing

each SBU as a stand-alone entity and ignoring synergies, treating the process as
largely mechanical, relying on strict rules for resource allocation, making overly
simplistic prescriptions and ignoring a firm’s potential long- term viability.
Example: Goal of Diversification = Risk Reduction?

 Diversification can reduce variability in revenues & profits over time. However,
Stockholders can diversify portfolios at a much lower cost & economic cycles are
difficult to predict, so why diversify?
Example = general electric’s businesses:
Aircraft engines, power generation equipment, locomotive trains, large appliances,
healthcare products, financial products, lighting, mining, oil & gas
Why is GE in so many businesses?

GE is widely diversified, although not as greatly as they once were – they used to
own NBC – the National Broadcasting TV group, which GE merged with Vivendi to
form NBC Universal – but divested this entity in 2011. With this divestiture, it could be
argued that GE is in the business of “imagination”, since all its remaining products,
except for the financial services business, can be considered offshoots of founder
Thomas A. Edison’s inventions that made life easier through technology. As the
chapter says, GE’s range of diversification has resulted in stable earnings over time,
and a very low risk profile. This allows them to borrow money at very favorable rates,
money that they, in turn, use to provide financing to buyers of their products –hence
the financial services division! So GE’s level of diversification DOES help the
company reduce risk.

Means of Diversification

Diversification can be accomplished via

 Mergers & acquisitions and divestment
 Pooling resources of other companies with a firm’s own resource base through
strategic alliances & joint ventures
 Internal development through corporate entrepreneurship

Diversification, either related or unrelated, allows a firm to achieve synergies and

create value for its shareholders. There are three basic means by which a firm can
diversify. Mergers are the combining of two or more firms into one new legal entity.
Acquisitions are the incorporation of one firm into another through purchase. Through
mergers and acquisitions, corporations can directly acquire another firm’s assets and
competencies. A firm can also divest previous acquisitions. Divestment is the exit of a
business from the firm’s portfolio. By using a joint venture or strategic alliance,
corporations can pool the resources of other companies with their own resource base.
Joint ventures are new entities formed within a strategic alliance in which two or more
firms, the parents, contribute equity to form the new legal entity. Strategic alliance is a
cooperative relationship between two or more firms. Finally, corporations may
diversify into new products, markets, and technologies through internal development.
Called corporate entrepreneurship, it involves the leveraging and combining of the
firm’s own resources and competencies to create synergies and enhance shareholder
value. Internal development is entering a new business through investment in new
facilities, often called corporate entrepreneurship and new venture development.

Mergers And Acquisitions

Mergers involve a combination or consolidation of two firms to form a new legal entity:
 are relatively rare
 the two firms are on a relatively equal basis
Acquisitions involve one firm buying another either through stock purchase, cash, or
the issuance of debt

Exhibit 6.6 Global Value of Mergers and Acquisitions ($ trillion)

Source: Thomson Financial, Institute of Mergers, Acquisitions, and Alliances (IMAA)

analysis

Exhibit 6.6 illustrates the dramatic volatility in worldwide M&A activity over the last
several years. Increase in merger and acquisition activity can indicate market
optimism. It’s an indication that markets are willing to finance these transactions.
Government policies such as regulatory actions and tax policies can also make the
M&A environment more or less favorable. Finally, currency fluctuations can influence
the rate of cross-border acquisitions with firms in countries with stronger currencies
being in a stronger position to acquire.

Mergers And Acquisitions: Motives

 In high-technology & knowledge-intensive industries, speed is critical: acquiring is

 faster than building.
 M&A allows a firm to obtain valuable resources that help it expand its product
offerings & services.
 M&A helps a firm develop synergy:
 leveraging core competencies
 sharing activities
 building market power
 M&A can led to consolidation within an industry, forcing other players to merge.
 corporations can also enter new market segments by way of acquisitions.

In certain industries speed is critical, so acquiring is faster than building.

Example = Apple acquiring Siri Inc. Acquisitions can quickly add new technology to
product offerings and meet changing customer needs. Example = Cisco Systems.

Acquisitions can help a firm leverage core competency, share activities, and
build market power. Example = eBay’s acquisition of GSI Commerce, PayPal, and
Zong allows it to become a full- service provider of online retailing systems.

M&A can lead to consolidation within an industry, forcing other players to merge.
Example = consolidation in the airline industry: Delta – Northwest, United
– Continental.

Corporations can also enter a new market segment by way of acquisitions.

Example = Fiat acquired Chrysler to gain access to the U.S. auto market.

Mergers And Acquisitions: Limitations

 Takeover premiums for acquisitions are typically very high

 Competing firms can imitate advantages
 Competing firms can copy synergies
 Managers’ egos get in the way of sound business decisions
 Cultural issues may doom the intended benefits

By estimates, 70 to 90% of acquisitions destroy shareholder value. See Strategy

Spotlight 6.3. Two times out of three, the stock price of the acquiring company falls
once the deal is made public. Since the acquiring firm often pays a 30% or higher
premium for the target company, the acquirer must create synergies and scale
economies that result in sales and market gains exceeding the premium price. This is
sometimes hard to do. Because competing firms can often imitate advantages or
copy synergies, investors may not be willing to pay a high premium for the stock.
M&A costs are paid for upfront. Conversely, firms pay for R&D, ongoing marketing,
and capacity expansion over time. This stretches out the payments needed to gain
new competencies, but investors want to see immediate results. If the M&A does not
perform as planned, managers who pushed for the deal may find their reputation
tarnished. Finally, creating a singular organizational culture from multiple national or
business cultures can be very difficult. Example = SmithKline and the Beecham
Group.
Mergers And Acquisitions: Divestment

Divestment objectives include:

 Cutting the financial losses of a failed acquisition
 Redirecting focus on the firm’s core businesses
 Freeing up resources to spend on more attractive alternatives
 Raising cash to help fund existing businesses

Divestments, the exit of the business from the firm’s portfolio, are quite common.
Large, prestigious U.S. companies may have divested more acquisitions than they
have kept. Investing can enhance a firm’s competitive position only to the extent that
it reduces its tangible (e.g., maintenance, investments, etc.) or intangible (e.g.,
opportunity costs, managerial attention) costs without sacrificing a current competitive
advantage or the seeds of future advantages. To be effective, divesting requires a
thorough understanding of the business unit’s current ability and future potential to
contribute to a firm’s value creation. Modes of divestment include sell-offs, spin-offs,
equity carve- outs, asset sales/dissolution, and split-ups.
Successful divestiture involves:
 Removing emotion from the decision
 Knowing the value of the business you’re selling
 Timing the deal right
 Maintaining a sizable pool of potential buyers
 Telling a story about the deal
 Running divestitures systematically through a project office
 Communicating clearly and frequently

Successful divestment involves establishing objective criteria for determining

divestment candidates. Clearly, firms should not panic and sell for a song in bad
times. Since the decision to divest involves a great deal of uncertainty, it’s very
difficult to make such evaluations. In addition, because of managerial self-interests
and organizational inertia, firms often delay investments of underperforming
businesses. The Boston Consulting Group has identified the above seven principles
for successful divestiture.

Strategic Alliances & Joint Ventures: Motives

Strategic alliances & joint ventures are cooperative relationships with potential
advantages:

 Ability to enter new markets through

greater financial resources
greater marketing expertise
 Ability to reduce manufacturing or other costs in the value chain
 Ability to develop & diffuse new technologies

Strategic alliances and joint ventures are assuming an increasingly prominent role in
the strategy of leading firms, both large and small. A strategic alliance can help firms
better understand customer needs, acquire know-how for promoting the product,
acquire access to the proper distribution channels. Example = Zara cooperating with
Tata in India. Strategic alliances enable firms to pool capital, value-creating activities,
or facilities in order to reduce costs. Example = SAB Miller and Molson Coors
combined brewery and distribution operations, benefiting from economies of scale
and better facility utilization. Strategic alliances may also be used to build jointly on
the technological expertise of two or more companies, enabling them to develop
products beyond the capability of other companies acting independently. Example =
Verizon Wireless and ILS technology can now securely transmit data to and from
various devices, including mobile devices and main office operations.

Strategic Alliances & Joint Ventures: Limitations

Need for the proper partner:

Partners should have complementary strengths
Partner’s strengths should be unique
 Uniqueness should create synergies
 Synergies should be easily sustained & defended
Partners must be compatible & willing to trust each other

Despite their promise, many alliances and joint ventures fail to meet expectations for
a variety of reasons. The proper partner is essential. However, unfortunately, often
little attention is given to nurturing the close working relationship and interpersonal
connections that bring together the partnering organizations.

Internal Development

Corporate entrepreneurship & new venture development motives:

 No need to share the wealth with alliance partners
 No need to face difficulties associated with combining activities across the value
chains
 No need to merge diverse corporate cultures
Limitations:
 Time-consuming
 Need to continually develop new capabilities

Internal development is such an important means by which companies expand their

businesses that there’s a whole chapter devoted to it. Compared to mergers and
acquisitions, firms that engage in internal development capture the value created by
their own innovative activities without having to share the wealth with alliance
partners or face the difficulties associated with combining activities across the value
chains of several firms or merging corporate cultures. On their own, firms can often
develop new products or services that are relatively lower cost, and thus rely on their
own resources rather than turning to external funding. However, this may be time-
consuming, so firms may forfeit the benefits of speed that growth through mergers or
acquisitions can provide. In addition, firms that choose to diversify through internal
development must develop capabilities that allow them to move quickly from initial
opportunity recognition to market introduction.
Managerial Motives: Antitakeover Tactics

Antitakeover tactics include:

 green mail
 golden parachutes
 poison pills
 can benefit multiple stakeholders – not just management
 can raise ethical considerations because the managers of the firm are not acting
in the best interests of the shareholders

Unfriendly or hostile takeovers can occur when a company’s stock becomes

undervalued. A competing organization can buy the outstanding stock of a takeover
candidate in sufficient quantity to become a large shareholder. Then it makes a
tender offer to gain full control of the company. If the shareholders accept the offer,
the hostile firm buys the target company and either fires the target firm’s management
team or strips them of their power. There are several antitakeover tactics. Greenmail
is a payment by a firm to a hostile party for the firm’s stock at a premium, made when
the firm’s management feels that the hostile party is about to make a tender offer.
Golden parachute is a prearranged contract with managers specifying that, in the
event of a hostile takeover, the target firm’s managers will be paid a significant
severance package. Poison pill is used by a company to give shareholders certain
rights in the event of takeover by another firm.