Session+Corporate+Diversification+2012

7/30/2019 Session+Corporate+Diversification+2012

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Escuela de Administracin

BUSINESS STRATEGY & LEADERSHIP

Corpo rate Strategy

Pontificia Universidad Catlica de Chile

Matko Koljatic

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Mission Objectives

External

Analysis

Internal

Analysis

Strategic

Choice

Strategy

Implementation

Competitive

Advantage

The Strategic Management Process

Corporate Level

Strategy

Which Businesses

to Enter?

Diversification

Vertical Integration

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Corporate

Strategy

Corporate

Head Office

Levels of Strategy and Organization Structure

Competitive

StrategyDivision A Division B

FunctionalStrategies

R & D

H R

Finance

Production

Marketing/Sales

R & D

H R

Finance

Production

Marketing/Sales

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Competitive vs. Corporate Level Strategy

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Key themes in Corporate Strategy

Portfolio Composition

Whichvalue chain activities should we be in?

Horizontal scope: Diversification (Endesa & General Electric cases)

Vertical scope: Integration/ Outsourcing (Toyota example)

Portfolio Change

Howshould we expand (shrink) our portfolio of value chainactivities?

Internal development organic growth (Apple case)

Alliances (Coors case - Coors / Molson initially)

Acquisitions / Divestitures (General Electric case )

Portfolio Organization

Howdo we organize to gain corporate advantage?

Corporate parenting (General Electric & J&J cases)

Re-structuring (General Electric case)

1 2 3 4 5 6 7

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Logic of Corporate Level Strategy

Corporate level strategy should create value:

1) Absent capitalmarket imperfections, corporate

advantage the improvements in profits from

creating a portfolio of businesses over and above the

profits of the same businesses operating individually -

must rest on some form of economies of scope

(synergies), such that businesses forming the

corporation have:

a higher Value than they would have under

independent ownership (V1;V2 < V1+V2), because ofsynergies in revenues (Y1; Y2 < Y1 + Y2) and or lower

costs ( C1+ C2 < C1; C2)

2) This higher Value can not be created by equity holders

through portfolio investing (next slide) 6


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Horizontal Synergies Across

Value Chains

PURCHASE MANUFAC. SALES & DIST.R&D

PURCHASE MANUFAC. SALES & DIST.R&D

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Value of Diversification

Business X Business Y Business Z

Independent: equity holder could buy shares of each firm only risk reduction

is captured by equity holders.

Value

BusinessX

Business Y

Business Z

Focal Firm

Value

+ +

Economies

OfScope

Combined: equity holder buys shares in one firm. Most economies of scope cannot be captured

by equity holders. If a corporate diversification move is unlikely to generate valuable economies ofscope, managers should avoid it.

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Types of Economies of Scope (Synergies)

In general, Economies of Scope occur when the firm achieves cost reductions

and/or revenue enhancement (i.e. cross selling) by operating two or more firms

Operational Sharing Activities: reducing costs by exploiting efficiencies of sharing business activities in the value chain

of two firms. Example: CCU Transportes

Spreading Core Competencies: reducing costs or enhancing revenue by exploiting resources and

capabilities which are strategically relevant in other businesses (Banks)

FinancialTax Advantages: Reducing costs by taking advantage of differentials in tax rates between countries orregions; transfer pricing policy allows profits in one division to be offset by losses in another division. This is

especially true internationally and can be used to smooth income

Example: Puerto Rico, Ireland and other tax havens.

Internal Capital Market : Capital cost reductions; premise: insiders can allocate capital across divisions

more efficiently than the external capital market (banks and institutional investors). Works only if managers

have better information than the market.

Risk reduction: counter cyclical businesses may provide decreased overall risk thus, lower costs.However, individual investors can usually do this more efficiently than a firm (CCU- VSP)

AnticompetitiveMultipoint Competition: mutual forbearance enhances revenue; a firm chooses not to competeaggressively in one market to avoid competition in another market (Unilever vs. P&G

Market Power: using profits from one business to compete in another business or by using buying power

in one business to obtain advantage in another business cost reductions

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Two Problems with Diversification

HQ Bureaucratic costsWhether HQs is creating or destroying value is typically hard to tell (or do anything about)

except in the most obvious casesHowever, markets are distrustful of Corporations which own multiple businesses and

undervalue their sharesthere is a lot of evidence of the conglomerate discount

Corporate HQ has a better chance of creating (or destroying) value during periods ofchange

than during steady state periods

HQ Costs

No revenues & overhead(bureaucratic costs: i.e.

corporate reporting

requirements)

Lack of close knowledge of

businesses

Encourages gaming behaviour

by division managers

HQ Benefits

Investment banker/consultant role Resources & Capabilities: Infrastructure,R&D, etc.

Superior management skills/ businessmodel

Enable collaboration between units

Managerialism (Agency Problems)Economy of scope that accrues to managers at the expense of equity holders. Managersof larger firms receive more compensation (larger size = more compensation). Therefore,

managers have an incentive to acquire other firms and become ever larger.

As the incentive could be there, it is difficult to know if Managerialism is the reason for an

acquisition 10


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http://www.quinenco.cl/pdf/presentation/Presentation_Quin

enco_Santander_January_2011.pdf

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Corporate Advantage

Happens if a Corporate Strategy meets the

VRIOcriteria

Is it Valuable?

Is it Rare?

Is it costly to Imitate?

Is the firm Organized to exploit it?

it may create a corporate advantage.

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Mission Objectives

External

Analysis

Internal

Analysis

Strategic

Choice

Strategy

Implementation

Competitive

Advantage


Corporate Level

Strategy

Whichvalue chain

activities should we be

in?


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Vertical Synergies Across Value Chains

The Logic of Value Chain Economies

Upstream

Downstream

If the focal firm is able to create

synergy with the other firm(s) in

the value chain through:

cost reductions

revenue enhancement (cross selling)

the focal firm is able to capture above normal economic returns

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Vertical Integration Profile(GM and Ford vs. Toyota)

Percent of

Total

Component

Costs

Arms-length

Suppliers

35%

Partner

Suppliers*

10%

Internally

Manufactured

55%

Arms-length

(Independent)

Suppliers

25%

Partner

Suppliers*

48%

Internally

Manufactured

27%

* 2 or less

suppliers for a

product category

GeneralMotors

andFordToyota

Source: Jeff Dyer, Collaborative Advantage, Oxford Press 2000

15
http://www.ford.com/en/links/General/www_fordvehicles_com/default.htm?referrer=homehttp://www.gm.com/


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Value of Vertical Integration

Market vs. Integrated Economic Exchange

economic exchange should be conducted in the formthat maximizes value for the focal firm

markets and integrated hierarchies (corporations) are

forms in which economic exchange can take place

thus, firms assess which form is likely to generate

more value

Integration makes sense when the focal firm can

capture more value than a market exchange provides16


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The Theory of Firm Boundaries

Ronald Coase, won the Nobel Prize in EconomicSciences in 1991 for the theory of firm boundaries

Coases question: Why do firms exist at all ? (instead of a

series of contracts between individuals who do what they

have competitive advantage at). Why are some economicactivities performed within firms and others within markets?

Answer:

Integration makes sense when the focal firm can

capture more value than a market exchange provides

Integration depends on comparison of total costs

production costs plus transaction costs the costs of

buying the product or service in the market (rather than

produce in-house).

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Production costs

Procure from Market In-house production

Transaction costs

Vertical Integration gains

Vertical Integration based on transaction cost

considerations

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Examples of Transaction Costs:

Costs of guarding

against opportunistic

behaviour by vendor

Finding reliable vendors

Drafting contracts

Enforcing contracts

Dispute resolution

Monitoring mechanisms

Costs of managing

interactions with a

(remote) vendor that

would have occurrednaturally in-house

Travel

(Tele) communications

Coordination mistakes Knowledge acquisition and

transfer

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Value of Vertical Integration:Three Value Considerations Regarding Internalizing

Leverage

Capabilities

Exploit

Flexibility

Manage

Opportunism

firm capabilities

may be sources

of competitive

advantage inother businesses

if not, then dont

integrate vertically

opportunism

may be checked

by vertical

integration

internalizing must

be less costly than

opportunism

vertical

integration is

usually less

flexible

flexibility is

valuable when

uncertainty is

high

Favor Vertical IntegrationDoes Not Favor


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International Expansion

Cost

(Capital at Risk)

ControlExporting

Licensing

Franchising

Strategic Alliance

Greenfield Investment

Low High

High

Acquisition

The Cost Control Tradeoff

VerticallyIntegrated

Not Vertically Integrated

Somewhat

Vertically

Integrated

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Mission Objectives

External

Analysis

Internal

Analysis

Strategic

Choice

Strategy

Implementation

Competitive

Advantage


Corporate Level

Strategy

Whichvalue chain

activities should

we be in?

Diversification

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Types of Corporate Diversification

Product Diversification:

Geographic Market Diversification:

Product-Market Diversification

operating in multiple industries

operating in multiple geographic markets

operating in multiple industries in multiple

geographic markets

At a general level

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Types of Corporate Diversification

Limited Diversification

Related Diversification

Unrelated Diversification

single business: > 95% of sales in single business

dominant business: 70% to 95% in single business

related - all businesses related on most

activities in the value chains

linked - some businesses related on some activities

businesses are not related Group or Conglomerate

At a more specific level

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Three key questions when diversifying

Is this a good industry to be in? The structural attractiveness of the industry PEST, 5 Forces+

Complementors, Life Cycle (Endesa case)

Would we enjoy a competitive advantage in thisindustry?

What is the NPV of investment in equity in other firm (Endesacase)

Would the gains from being in both businessesoutweigh the cost of entry?

Acquisition premium (premium over market price of shares) vs.the cost of internal development

Are there any synergies with current business

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Its 1970...

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1949 1954 1959 1964 1969 1974

70.2

The great diversification boom:

1950-1975: Fortune 500

63.553.7 53.9

39.937.0

29.8

36.5

46.3 46.1

60.1 63.0

Percentage of Specialized Companies (single-business, vertically-

integrated and dominant-business)

Percentage of Diversified Companies (related-business and

unrelated business)

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Good economic conditions - companies emphasized

growth over profitability

The rise to eminence of consulting firms

The spread of the M-form (multi-divisional structure)

Portfolio management techniques

The belief in generic management techniques and skills

Why did it happen?

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Is this statement true?

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Industry Attractiveness

Criteria Market size

Market growth

Industry profitability

Inflation recovery

Overseas sales ratio

In

dustry

Attractiveness

Portfolio Planning Models:

The GE/ McKinsey Matrix

Business unit position

Low

Medium

High

Low Medium High

Business Unit Position

Criteria

Market share (domestic, global,

and relative)

Competitive position

Relative profitability30


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HIGH

Portfolio Planning Models:The BCG Growth-Share Matrix

LOW

HIGH

LOW

Annua

lrealrateofmark

etgrowth(%)

Relative market share

Earnings: high stable, growing

Cash flow: neutral

Strategy : invest for growth

Earnings : high stable

Cash flow: high stable

Strategy : milk

Earnings : low, unstable

Cash flow: neutral or negative

Strategy : divest

Earnings: low, unstable, growing

Cash flow: negative

Strategy : analyze to determine whether

business can be grown into a

star, or will degenerate into a

dog

???

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Annualrealrateofma

rketgrowth(%)

Relative market share

2 1.5 1 0.5 0.1

-2

0

2

4

6

8

10

Frozen

food

division

Fruit juices

division

Bakery

division

Health

foods

division

Portfolio Planning Models: Applying the BCG

Matrix to a Foods company

Current position

Strategy: invest for

growth

Strategy: analyze to

determine whether

business can begrown into a star, or

will degenerate into

a dog

Strategy: milk

Strategy: divest

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Do Portfolio Planning Models Help or Hinder

Corporate Strategy Formulation?

ADVANTAGES

Simplicity (?) & Big picture

Analytically versatile

DISADVANTAGES

Sensitive to market definition

Ignores Resources & Capabilities Ignores synergies

Reduces investments in Cash

Cows; invests in business in

which Cos may not haveCompetitive Advantages

Ignores financing from

capital markets

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Drop in diversification index of Fortune 500 by 33%

between 1980-1990

The most diversified companies became less diversified.

While M&A levels were high, divestments were higher

Re-focusing in the 80s.

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Goals shifted from growth to profitability as economic

conditions tightened.

Shareholder activism and shareholder value ideology

(Finance professors made their mark !)

Innovations in debt financing (LBO= Leveraged Buy Outs)

Turbulent market conditions expose weaknesses of large

bureaucracies

Why did this happen?

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Distinguishing related from unrelated diversificationnot all

diversification is bad.

The Theory of Resource Advantage: resources and

capabilities are a source of advantage both at the

competitive and corporate level

Multiple alternatives for entering new businesses-alliances,

M&A (Mergers and Acquisitions), JVs (Joint Ventures), etc.

Organizational economics: economies of scope

Corporate Strategy in the 90s

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What makes for successful corporate

strategy?

Porter (87)

Attractiveness

Cost of entry Better off (next slide)

Montgomery and

Collis(98)

The companys

businesses must not be

worth more to another

buyer

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Porters better off test

Sharing

Tangible assets

Transferring

Intangible assets

Portfolio

Restructuring

Integration between divisions

Integrationbetween

HQ-division

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Market Activated Corporate Strategy


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Market Activated Corporate Strategy

(MACS): Who is the Best Owner

McKinsey in the 21st Century

Natural

Owner

One of

the

Pack

HI Medium Low

Business units value creation potential

as a stand alone enterprise

Parents Company

ability to extract value

from the business unit,

relative to other

potential owners

Business

units (radius

denotes

value added)39


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Diversification: some reflections

Diversification into related businesses can add value

Relatedness can be measured in the How (i.e. thevalue chain) , Who (cross selling) or What (i.e.

manufacturing, branding, etc.) Understand the sources of synergies and implications for

management, risk, regulation

How will external stakeholderreact? (remember LANTAM)

Even with a good diversification strategy, you can end upwith egg on your face

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Thus, after decades of research the

overwhelming conclusion must be that M&Aactivity, on average, does not positively

contribute to an acquiring firms performance.

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How should we expand (shrink) our portfolio


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Howshould we expand (shrink) our portfolio

of value chain activities?Entering new businesses/scaling up current ones

Non-equity

alliances

Equity alliances

Acquisitions

Organic Growth

New product development,

Internal corporate ventures

Inorganic Growth

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O i (I t l) I i


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Organic (Internal) vs. Inorganic

(Diversification) development

Need forspeed favours inorganic growth -

organic growth is slow and uncertain

Availability ofrelated resources and capabilities

within the company to build on favours organic

growth

Market maturity - prospective acquisitions to

gain market share favors inorganic growth-

especially in geographic diversification

Regulation can sometimes force divestituresbecause of antitrust restrictions (i.e. Copec

Terpel)

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Matko Koljatic

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Organic Growth

Advantages

incremental

compatible withorganizational

culture

Promotes

intrapreneurship

Internal investment

Disadvantages

slow

Forces to developnew resources and

capabilities

Increases installed

capacity; entry may

not be at scale size

Failures are not

recoverable


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Matko Koljatic

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Mergers and Acquisitions

Advantages Eliminates competitors

Synergies in revenues

(cross selling) and costs

(less duplications) easy to

assess

Fast

Access and Upgrade of

complementary Resources

and Capabilities

Disadvantages

Cost of acquisition

(premium)

Bureaucratic costs

Acquisition of

resources which are

not needed

Organizational

conflicts may occur

Commitment of large

resources - risk


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Matko Koljatic

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Alliances

Advantages

Access to

complimentary

resources revenue

enhancement

(OneWorld)

Fast

Disadvantages

Lack of control

Helps a competitortoo

Long term viability,

questionable

Difficulty inintegration and

learning


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Summary

Corporate Strategy:In what businesses should the firm operate?

an understanding of diversification helps managers

answer that question

Two Criteria:

1) economies of scope must exist

2) must create value that outside equity holders

cannot create on their own

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Summary

Economies of Scope

a case of synergycombined activities generate

greater value than independent activities

may generate competitive advantage if they

meet the VRIO criteria

Firms should pursue diversification only if carefulanalysis shows that corporate advantage is likely!

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