Corporate Strategy: Vertical Integration and Diversification

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 8-2Describe and evaluate different options firms have to organize economic activity. LO 8-3Describe two types of vertical integration along the industry value chain: backward and forward vertical integration. LO 8-4Identify and evaluate benefits and risks of vertical integration. LO 8-5Describe and examine alternatives to vertical integration. LO 8-6Describe and evaluate different types of corporate diversification. LO 8-7Apply 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 • 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. 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

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

10. LO 8-1Define corporate-level strategy, and describe the three dimensions along which it is assessed. LO 8-2Describe and evaluate different options firms have to organize economic activity. LO 8-3Describe two types of vertical integration along the industry value chain: backward and forward vertical integration. LO 8-4Identify and evaluate benefits and risks of vertical integration. LO 8-5Describe and examine alternatives to vertical integration. LO 8-6Describe and evaluate different types of corporate diversification. LO 8-7Apply 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.

11. 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

12. 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)

13. Organizing Economic Activity: Firm vs. Markets EXHIBIT 8.2

14. 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 

15. EXHIBIT 8.3 Alternatives along the Make or Buy Continuum

16. 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 1–16 China Rare Earth Video

17. LO 8-1Define corporate-level strategy, and describe the three dimensions along which it is assessed. LO 8-2Describe and evaluate different options firms have to organize economic activity. LO 8-3Describe two types of vertical integration along the industry value chain: backward and forward vertical integration. LO 8-4Identify and evaluate benefits and risks of vertical integration. LO 8-5Describe and examine alternatives to vertical integration. LO 8-6Describe and evaluate different types of corporate diversification. LO 8-7Apply 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.

18. 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

19. Backward and Forward Vertical Integration along an Industry Value Chain EXHIBIT 8.4

20. 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 equallyprofitable Zara – primarily designs in-house & partners for speedy new fashions delivered to stores

21. HTC’s Backward and Forward Integration along the Industry Value Chain in the Smartphone Industry EXHIBIT 8.5

22. LO 8-1Define corporate-level strategy, and describe the three dimensions along which it is assessed. LO 8-2Describe and evaluate different options firms have to organize economic activity. LO 8-3Describe two types of vertical integration along the industry value chain: backward and forward vertical integration. LO 8-4Identify and evaluate benefits and risks of vertical integration. LO 8-5Describe and examine alternatives to vertical integration. LO 8-6Describe and evaluate different types of corporate diversification. LO 8-7Apply 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.

24. 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

25. 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

27. 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 1–27

28. 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

29. 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.

30. 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

32. 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

33. Different Types of Corporate Diversification EXHIBIT 8.7

34. 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. 1–34 Exxon XTO video

35. LO 8-1Define corporate-level strategy, and describe the three dimensions along which it is assessed. LO 8-2Describe and evaluate different options firms have to organize economic activity. LO 8-3Describe two types of vertical integration along the industry value chain: backward and forward vertical integration. LO 8-4Identify and evaluate benefits and risks of vertical integration. LO 8-5Describe and examine alternatives to vertical integration. LO 8-6Describe and evaluate different types of corporate diversification. LO 8-7Apply 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.

36. 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)

37. 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

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

39. 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

40. 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.

41. 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.

42. Corporate Diversification Diversification discount Stock price of diversified firms is less Diversification premium Stock price of diversified firms is greater Will diversification increase performance?

43. The Diversification-Performance Relationship EXHIBIT 8.9

44. Vertical Integration and Diversification: Sources of Value Creation and Costs EXHIBIT 8.10

45. BCG Matrix EXHIBIT 8.11

47. 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

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