CH-6 Corporate-Level Strategy: Creating Value through Diversification – Strategic Management: Creating Competitive Advantages : Book Guide

Chapter 6 Corporate-Level Strategy Creating Value through Diversification Summary/Objectives Whereas business-level strategy (Chapter 5) deals with the question of how to compete in a given industry, corporate level strategy addresses two related issues. These are: (1) what businesses should we compete in, and (2) how can these businesses be managed in a way to create “synergy,” that is, more value by working together than if they were free-standing units. This chapter is divided into six major sections: 1. We begin by posing the question why do some corporate level strategic efforts fail and others succeed? We emphasize the importance of diversification activities that create shareholder value, whether through mergers and acquisitions, strategic alliances and joint ventures, or internal development. 2. We address how related diversification can help a firm attain economies of scope through either leveraging core competencies or sharing activities (such as production facilities or distribution facilities). 3. We discuss how firms can benefit from related diversification through greater market power. Here, we address pooled negotiating power and vertical integration. 4. The fourth section discusses how firms can benefit from unrelated diversification. There are two key means to this end: corporate parenting and restructuring, as well as portfolio management. 5. The fifth section focuses on the means that firms can use to achieve diversification. The means include mergers and acquisitions; strategic alliances and joint ventures; and internal development. We discuss the advantages and disadvantages associated with each of these. 6. We close the chapter with a section on how managerial motives can erode value creation as firms pursue diversification initiatives. These include growth for growth’s sake, egotism, and anti-takeover tactics (e.g., greenmail, poison pills). Lecture/Discussion Outline The Flip Video opening case points out how Cisco saw early market success with its acquisition of Flip but how quickly this value eroded as Cisco was not able to follow up its initial success with new products in this rapidly changing market. This is a clear example of failed diversification. When Cisco purchased Flip in 2009 for $590 million, the company saw its purchase as a chance to move boldly into the consumer market. Cisco is a powerhouse in the computer network industry and was looking to expand into new territory with the Flip purchase. However, Cisco shut down the Flip business only two years later. Cisco failed with the Flip acquisition for two main reasons. First, Flip operated in an industry very different than Cisco’s core operations. Cisco is a computer networking firm who sells hardware and software to corporate users. As a result, Cisco didn’t really have the competencies necessary to compete in the consumer video systems market. Second, large diversified firms can become bureaucratic and slow in responding to market changes. This was critical in the failure of Flip since Cisco was slow to respond to a key market shift. Consumers wanted devices that would allow them to seamlessly upload video to social media sites, but Flip was slow to add this capability to its cameras. In the end, Flip lost its ability to compete with the range of competing products, including smart phones and tablets, that offered the capability to capture and share video images.  Discussion Question 1: Would Flip have had a better chance at success as a stand-alone firm than it did as part of Cisco? Why or why not? Response guidelines: As a stand-alone firm, Flip was successful and growing. As a part of Cisco, Flip failed. Since Flip largely failed due to Cisco’s inability to respond to market changes, Flip would have likely had a better chance of success as a stand-alone firm since it would have been more responsive to the market. From the case vignette, Cisco’s inability to manage the new business was central in the firm’s failure. There are two main reasons for this. First, Cisco has capabilities in business networking equipment and software. This business is very different from Flip’s business of selling video cameras to individual customers. Cisco did not have the knowledge and understanding necessary for competing in this new business. Second, perhaps Cisco could have developed the needed knowledge and capability for competing in this business, but it was not regarded as important enough to warrant the investment. Flip represented only 1% of Cisco’s revenues, and senior management did not give the new business opportunity enough attention to enable it to succeed. Answer: Flip might have had a better chance at success as a stand-alone firm due to its ability to focus solely on its niche market and innovate without the constraints of a larger corporate structure. However, being part of Cisco provided access to broader resources and technology integration. The key factors include Flip's need for agility and niche focus versus Cisco's broader strategic priorities and potential integration challenges.  Discussion Question 2: Cisco didn’t have the right market focus or competencies to win with Flip. What firms could have succeeded by acquiring Flip? Response guidelines: After discussing question 1, students should be able to think about the type of firm that would successfully develop a presence in Flip’s business. The successful acquirer would have two characteristics; 1) it would have some capability in the business of selling video cameras, or other similar products, to individual customers, and 2) it would give the new business the needed investment for succeeding. Flip’s business is dynamic and growing, with changing consumer preferences, so any successful acquirer should be actively engaged with individual users of electronic equipment, social media, and communications technology. These ideas suggest that some well-known names in the industry, such as Apple, Google, and Facebook might have had better success. Facebook in particular showed a capability in this area with its acquisition of Instagram. A less attractive set of acquirers would be more traditional electronics firms such as Sony, Matsushita, or Samsung. These firms may be less adept at navigating the dynamic business environment than Google. However, if a traditional electronics firm makes a strategic commitment to the social media and communications technology, then it could succeed with the acquisition of Flip. We next point out that Cisco’s failure at diversification is hardly unique. Rather, many diversification efforts do not lead to the intended results. We then summarize several studies conducted over the last thirty years that investigate the relationship between diversification strategies and firm performance. Overall, the results are quite negative – sensitizing students to the challenges inherent in increasing shareholder value through diversification. Answer: Firms like Apple or Sony, with strong consumer electronics focus and innovative capabilities, might have succeeded by acquiring Flip. Their expertise in consumer markets and product development could have better leveraged Flip's technology and brand. EXHIBIT 6.1 identifies six well-known recent M&A failures. It is used to reinforce the point that most diversification efforts fail. Thus, “making it work” becomes a real challenge for strategic managers. A summary question would be:  Discussion Question 3: Why do most diversification efforts fail? Answer: Most diversification efforts fail because companies often lack the necessary expertise or market knowledge in the new area, leading to poor strategic fit and execution challenges. Diversification can stretch resources too thin, diluting focus and effectiveness. Additionally, acquiring or entering new markets often involves cultural and operational integration issues. Inadequate research and overestimation of synergy potential can also contribute to failure. Ultimately, a mismatch between the core competencies of the company and the demands of the new market often undermines success. The SUPPLEMENT below points out that even successful firms can struggle with acquisitions and that there are a number of reasons that acquisitions can fail. P&G went through a lengthy examination of its acquisition experiences to learn and improve.  Extra Example: Procter and Gambles Struggles with and Learns from Acquisitions When A.G. Lafley was the CEO of Procter and Gamble, he commissioned a study to assess the level of success and failure the firm had experienced with its acquisitions. He was shocked to find that, when they looked at the acquisitions P&G had undertaken from 1970-2000, less than 30% of them met the investment objectives of the acquisition and were deemed successful. They further found that failures typically resulted from one or more of the following five factors: (1) absence of a winning strategy for the combination, (2) not integrating the acquired unit well or quickly enough, (3) expected synergies didn’t materialize, (4) cultures that weren’t compatible, and (5) leadership that couldn’t play well together. Thus, one of the root causes related to a lack of strategic logic. The other four revolved around the inability to make a potentially valuable acquisition work, often because of personal or cultural differences. However, Lafley didn’t stop there. He was determined to have P&G learn from their mistakes. He and his team took the results of this assessment and changed their acquisition integration processes. They saw their success rate with acquisitions rose from 30% to 60% over the 2001-2010 time period, partly as a result of this exercise. Source: Dillon, K. 2011. I think of my failures as a gift. Harvard Business Review. 89(4): 86-89. Some general questions to spur discussion and debate:  Discussion Question 4: Why is it typically necessary to integrate the acquiring and acquired firm to have an acquisition succeed? Answer: Integrating the acquiring and acquired firms is essential for a successful acquisition because it aligns resources, processes, and cultures to realize synergies and efficiencies. Effective integration helps to unify goals, streamline operations, and capitalize on complementary strengths, ensuring that the combined entity operates as a cohesive unit rather than two disparate organizations. Discussion Question 5: Why is it so difficult to integrate firms together after an acquisition? Answer: Integrating firms after an acquisition is challenging due to differences in corporate cultures, management styles, and operational processes. These disparities can lead to resistance, miscommunication, and inefficiencies. Additionally, aligning IT systems, blending teams, and harmonizing strategic objectives require substantial effort and can disrupt ongoing operations. I. Making Diversification Work: An Overview Despite the gloomy performance of some M&As, not all deals erode profitability. Examples of successful mergers include British Petroleum’s acquisition of Amoco and Arco, and the Renault-Nissan merger. The question becomes, why do some diversification efforts fail and others succeed? At the end of the day, diversification initiatives — whether via mergers and acquisitions, strategic alliances and joint ventures, or internal development — must be justified by the creation of value for shareholders. Firms can either diversify into related or unrelated businesses. With related diversification, the primary benefits are to be derived from horizontal relationships — businesses sharing intangible resources (i.e., core competencies) and tangible resources (e.g., production facilities, distribution channels). For example, Procter & Gamble enjoys many synergies from having multiple businesses that share distribution resources. With unrelated diversification, the primary benefits are derived largely from vertical relationships, that is, value that is created by the corporate office. This would include infrastructure activities such as information systems and corporate culture/leadership, sound businesses practices that have been honed by the corporation over time, and human resource practices. EXHIBIT 6.2 provides an overview of how we will address the various means by which firms create value through both related and unrelated diversification. The exhibit also includes an overview of some of the examples that we have in this chapter. II. Related Diversification: Economies of Scope and Revenue Enhancement Related diversification enables a firm to benefit from horizontal relationships across different businesses in the diversified corporation. There are two means for accomplishing this: (1) leveraging core competencies, and (2) sharing activities. Such horizontal relationships across businesses enable the corporation to benefit from economies of scope which refers to cost savings due to the breadth of operations. Additionally, a firm can enjoy greater revenues if two businesses attain higher levels of sales growth combined than either business could independently. The SUPPLEMENT below provides the example of American Express — a firm whose diversification strategy is succeeding because it is leveraging its core competencies as it moves into new markets.  Extra Example: American Express: A Successful Diversification Strategy When you say American Express, most people think of a credit card that is aimed toward higher income individuals. This impression, though still somewhat true, is becoming less accurate over time. It is true that 80% of American Express’ revenue comes from transaction fees for credit card purchases, but over the last several years, American Express has diversified into traditional banking services and financial services for the “unbanked.” At the height of the financial crisis in late 2008, American Express became a bank holding company. This allowed it to offer traditional banking services, such as savings accounts. It has leveraged its brand name and longstanding relationships with customers to sell its banking services. More recently, it has begun offering pre-paid debit cards that are aimed at young and lower income individuals who do not have formal bank accounts. In this effort, it is again leveraging its well established brand name to sell the cards. It is also enlisting the cooperation of major retailers, such as Walmart, to promote and sell the cards. In these cases, American Express is leveraging its relationships with retailers who have long accepted American Express credit cards. Looking forward, American Express can use the information they collect on the incomes, credit history, and purchasing patterns of the users of the AmEx Bluebird debit cards to know what additional services, such as banking and credit cards, to cross-sell to them. With these diversification efforts, American Express is leveraging some key resources and competencies, including its brand, its relationships with retailers, and its information systems to expand outside its traditional core business into related markets. Source: Summers, N. 2012. American Express wants to be your banker. Bloomberg Businessweek. October 29: 46-48. Leveraging Core Competencies We begin with the imagery of a tree to illustrate the concept of core competencies. Core competencies represent the root system (not the leaves) and competitors can make a big mistake if they believe a firm’s strength is in their leaves (by analogy). Core competencies may be considered to be the “glue” that binds existing businesses together or as the engine that fuels new business growth. Core competencies — to create synergy for a corporation — must satisfy three conditions: • The core competence must enhance competitive advantage(s) by creating superior customer value. (Gillette) • Different businesses in the corporation must be similar in at least one important way to benefit from the core competence. (IBM) • The core competencies must be difficult for competitors to imitate or find substitutes for. (Amazon) STRATEGY SPOTLIGHT 6.1 discusses how IBM is leveraging its core competencies in building computing systems that can process natural language and make decisions to become a leading healthcare services firm.. Teaching Tip: Although many companies have core competencies, not all seem to be able to leverage them. You may ask students to speculate why so many firms fail to leverage their core competencies. Possible reasons may include failure to recognize opportunities to leverage, lack of complementary competencies, or problems with culture, structure, and reward systems within the organization. This serves to reinforce the integrative nature of strategy formulation and implementation and the interconnections among the various aspects of organizational strategies, structures, and systems. We also address Steve Jobs’ insights on Apple’s core competence. The SUPPLEMENT below points out how luxury car manufacturers are leveraging their core competencies by investing in toys that complement their regular car offerings.  Extra Example: For Luxury Automakers, Selling Toys is no Game The three big German automakers, BMW, Mercedes, and Volkswagen’s Audi have been locked in a tight fight for the domination of the luxury car market. Besides competing in automobiles, they have extended their product lines to include playground offerings, with sleds and push cars that target the next generation of drivers. The top offering came from Audi with a scale model of its 1930’s racer, the Auto Union Type C, which retailed for $13,300, and quickly sold 400 out of the total of 500 that were produced. The toy car is suitable for children up to 4 feet 5 inches and features an aluminum frame, oak dashboard, leather-clad steering wheel and seven speeds. As an alternative, Audi also offers a plastic pedal-powered version of the Type C for $410. While BMW offered snow sleds with either a Mini or a BMW brand for approximately $110, Mercedes countered with a toddler version of its gull-wing SLS supercar for $123. To ensure that their toys represent the technological prowess and quality that their automobiles represent, luxury carmakers go to great lengths to make sure their toys stand out. Mercedes’ foot-powered SLS Bobby-Benz is designed to closely resemble its $183,000 counterpart, and features quiet running tires, tight steering, and an impact-absorbing steering wheel. BMW’s snow sled features replaceable metal runners, a horn, as well as a suspension-system in the steering ski. The technology the firms use in its toy offerings is partially derived from its automotive products, and helps them leverage their core competences, thus obtaining more than just some additional sales, through product positioning in the mind of the next generation of drivers. Skills and retail space used to sell luxury automobiles are also used to tap into a new market segment--premium toys--and also to further reinforce their value proposition, by reinforcing their brand image. Source: Reiter, C. 2010. For luxury automakers, selling toys is no game. Bloomberg Businessweek. November 29: 26.  Discussion Question 6: Given the high cost of producing quality toys that would sustain the rigors of child play, is this a good strategy (if the toys break, it would reflect negatively on the company)? Answer: Investing in the production of high-quality, durable toys is a good strategy despite the high cost because it builds brand trust and reduces negative impacts from product failures. High-quality toys enhance customer satisfaction and loyalty, potentially leading to greater market share and long-term profitability. The initial investment in durability pays off by reducing returns and negative reviews, ultimately strengthening the company's reputation. Discussion Question 7: Should the firms focus only on doing what they do best, namely produce cars? Why/why not (benefits/costs)? Answer: Focusing solely on producing cars allows firms to leverage their core competencies, streamline operations, and potentially achieve economies of scale. This focus can drive innovation and operational efficiency within the automotive sector. However, it may limit opportunities for diversification and risk mitigation, making the firm vulnerable to industry-specific downturns. Balancing core activities with strategic diversification can offer stability while exploring new growth avenues. Sharing Activities Synergy can also be achieved by sharing tangible activities across business units. These include value-creating activities such as common manufacturing facilities, distribution channels, and sales forces. Sharing activities provide two potential benefits: cost savings and revenue enhancements. 1. Deriving Cost Savings through Sharing Activities Cost savings come from many sources such as eliminating jobs, facilities, and related expenses that are no longer needed when functions are consolidated. We provide the example of Shaw Industries, a leading player in the carpet industry. 2. Enhancing Revenue and Differentiation through Sharing Activities At times, an acquiring firm and its target may attain a higher level of sales growth together than either company could do on its own. We provide the example of Starbuck’s acquisition of La Boulange, a small bakery chain. Firms can also increase the effectiveness of their differentiation strategies via sharing activities among business units. The SUPPLEMENT below discusses how Target was able to enhance its revenues by diversifying into grocery retailing in its stores.  Extra Example: Target Enters the Grocery Retailing Industry Target is a go to location for many consumers to purchase stylish yet affordable clothes, picture frames, lamps, and kitchen appliances as well as basic toiletries and paper products. Now, Target wants to be your favorite stopping point for chicken, fresh fruit, and other grocery products. Target has invested over a billion dollars in recent years to redesign its stores to carry a full line of food products. It now has a grocery section in over half of its stores. Why have they made this push? The grocery business is a notoriously low margin business with a number of strong, entrenched competitors. Target sees it as an opportunity to drive traffic into its stores. Customers typically shop for groceries two to three times a week but only visit discount stores about once a month. If Target can get customers in to pick up some bananas or a loaf of bread, they may also choose to pick up a DVD and a new pair of shorts while they are in the store. So far, it appears to be working. Sales and traffic in stores with the grocery sections has been six percent higher than in similar stores without them. Source: Clifford,m S. 2011. Big retailers fill more aisles with groceries. Nytimes.com. January 6: np. III. Related Diversification: Market Power Here, we address two principal means by which firms attain synergy through market power: pooled negotiating power and vertical integration. Note that managers have limits on their ability to use market power for diversification — government regulations can sometimes restrict the ability of a business to gain very large shares of a particular market. (Also, we discuss why the attempted acquisition of T-Mobile by AT&T was blocked by regulators). A. Pooled Negotiating Power Similar businesses working together or the affiliation of a business with a strong parent can strengthen an organization’s bargaining power in relation to suppliers and customers as well as enhance its position vis a vis its competitors. We provide the comparison of an independent food producer with the situation in which the same business is part of a giant player such as Nestle. We also note that managers must evaluate how the combined business may affect relationships with actual or potential competitors, suppliers, and customers. We give the example of how PepsiCo failed to entice McDonald’s as a customer since they had for a number of years owned competing business units (KFC, Taco Bell, and Pizza Hut). The SUPPLEMENT below provides another example of how Mars was able to enhance its bargaining power via an acquisition of Wrigley.  Extra Example: Mars Increases Its Market Power with the Acquisition of W. Wrigley Co. In April 2008, Mars purchased W. Wrigley Co. for $23 billion. This brought together two companies that had complementary market positions in the candy market. Mars had a large portfolio of products but was strongest in chocolate candy. Wrigley was primarily a gum firm but had products in other segments in the candy market. With the acquisition, the combined firm became the largest confectionary firm in the world with 14.4 percent market share. The combined size of the firm and the range of products it sells within the candy market gives the firm tremendous power over suppliers, such as sugar producers. It also helped to blunt the growing power of major retailers, such as Walmart, since Mars has a large product line of high demand, branded products. Source: Wiggins, J. & Macintosh, J. 2008. Mars and Buffet in $23bn Wrigley deal. Ft.com. April 28: np. B. Vertical Integration Vertical integration represents an expansion or extension of the firm by integrating preceding or successive productive processes. That is, the firm incorporates more processes toward the original source of raw materials (backward integration) or toward the ultimate consumer (forward integration). STRATEGY SPOTLIGHT 6.2 provides the example of Shaw Industries (the carpet producer) that has engaged in both backward integration (i.e., acquiring fiber manufacturing facilities) as well as forward integration (i.e., acquiring floor covering retailers). EXHIBIT 6.3 illustrates the stages of vertical integration for Shaw Industries. We address the benefits and risks of vertical integration. They are summarized in EXHIBIT 6.4. In making decisions associated with vertical integration, five issues need to be considered: 1. Is 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 that are presently being outsourced or performed by others independently that are viable sources 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 initiative have potential negative impacts on the firm’s stakeholders? We discuss how vertical integration can be analyzed from the transaction cost perspective. We note that every transaction involves transaction costs: search costs, negotiating, contracting, monitoring, and enforcement. Another problem – transaction – specific investments – occurs when purchasing a specialized input from outside. Vertical integration, on the other hand involves a different set of costs – administrative. Thus, if transaction costs are higher than administrative costs, vertical integration should occur. IV. Unrelated Diversification: Financial Synergies and Parenting We now address unrelated diversification. Here, unlike related diversification, there are few benefits to be derived from horizontal relationships, that is, the leveraging of core competencies or the sharing of activities across business units in a corporation. In unrelated diversification, the benefits are to be gained from vertical (or hierarchical) relationships, i.e., the creation of synergies from the interaction of the corporate office with the individual business units. There are two main sources of such synergies: • the corporate office can contribute to “parenting” and restructuring of (often acquired) businesses, and • the corporate office 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. A. Corporate Parenting and Restructuring The positive contribution of the corporate office has been referred to as the “parenting advantage.” Many parent companies such as Berkshire Hathaway and Virgin Group create value through management expertise. We provide the example of KKR, a private equity firm, whose parenting approach is used to improve the performance of multiple segments of the acquired firms’ value chains. Restructuring is another means by which the corporate office can add substantial value to a business. Here, the corporate office tries to find either poorly performing firms with unrealized potential or firms in industries on the threshold of significant, positive change. We address three types of restructuring: Asset Restructuring, Capital Restructuring, and Management Restructuring. For restructuring strategies to work, corporate management must have both the insight to detect undervalued companies (otherwise the cost of acquisition would be too high), or businesses competing in industries with high potential for transformation. Also, they must have the requisite skills and resources for turning the businesses around — even if they are new and unfamiliar businesses. B. Portfolio Management Here, the key concept is the idea of a balanced portfolio of businesses. This consists of businesses whose profitability, growth, and cash flow characteristics would complement each other, and add up to satisfactory overall corporate performance. 1. Description and Potential Benefits The Boston Consulting Group’s growth/share matrix is among the best known of these approaches. 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. EXHIBIT 6.5 illustrates the BCG matrix. We describe the labels for each of the four quadrants of the matrix – stars, question marks, cash cows, and dogs. In using a portfolio strategy approach, a corporation tries to create synergies and shareholder value in a number of ways. Since the businesses are unrelated, synergies that develop are the result of the actions of the corporate office interacting with the individual units, i.e., vertical relationships, instead of across business units, i.e., horizontal relationships.  Discussion Question 8: What are the main advantages of portfolio approaches? (e.g., provide good snapshot to help allocate resources, helps determine attractiveness of acquisitions, can provide funds to business units at favorable rates, corporate office can provide high quality review of business units, and, provides a basis for developing strategic goals and reward and evaluation systems) Answer: Portfolio approaches offer several advantages: they provide a clear snapshot of the company's overall performance, aiding in effective resource allocation. They help assess the attractiveness of acquisitions by evaluating how they fit within the existing portfolio. Additionally, they enable the corporate office to provide targeted support and favorable funding to promising business units. Portfolio analysis also facilitates high-quality reviews and strategic goal setting, aligning performance metrics and rewards with overall corporate objectives. The SUPPLEMENT below provides another example — Procter & Gamble — of portfolio analysis.  Extra Example: The Use of Portfolio Management at Procter & Gamble The following is excerpted from a presentation: “Remarks to Financial Analysts” by A. G. Lafley, President and CEO and C. Daley, CFO of Procter & Gamble Company on September 28, 2000 in New York City: “As to where to invest for future growth, that requires an assessment of our portfolio. I’m not ready to talk about portfolio decisions, but I can share the process, the criteria, and the timetable. “I am personally evaluating the industry attractiveness of all the business categories we currently play in. I’m comparing industry attractiveness to P&G capabilities and financial goals. “Within each industry, I’m reviewing the strategy, business health and financial performance of the best-performing company — whether P&G or a competitor. “If a competitor, I’m comparing P&G’s performance to that competitor and to industry average performance. This is the first important step — facing up to current reality, understanding how P&G is really performing, and who’s winning today. “In business categories where we are the leader and setting the performance benchmark, I’m focusing on strategy that will widen our margin of leadership. “In business categories where we are currently a strong number two, I am asking for a strategy and plans to become the leader, and to perform at least as well, and ideally better, than the current best competitor. “In business categories where we are not the leader and only delivering average returns, I’m asking how we’re going to get better-than-average industry returns fast. “Finally, in businesses where we’re struggling and under-performing, I’m asking for a “Fix-It-Fast” plan or an alternative resolution. I’ll have little patience for these.”  Discussion Question 9: What do you think are some of the benefits (drawbacks) of this approach? Answer: Benefits of a portfolio approach include improved resource allocation, strategic alignment, and enhanced decision-making through comprehensive performance insights. It allows for better evaluation of investments and supports targeted support for high-potential units. However, drawbacks can include the potential for excessive focus on short-term metrics at the expense of long-term strategy, and the risk of internal competition for resources. Additionally, it may lead to a lack of flexibility, as rigid portfolio management can stifle innovation and adaptation to market changes. 2. Limitations We then provide some of the limitations and disadvantages of portfolio approaches such as the BCG matrix.  Discussion Question 10: What are the primary limitations of portfolio approaches? (too simplistic — only two dimensions, ignores potential synergies across businesses, process can become too mechanical, may rely on overly strict rules to allocate resources, and, the imagery may lead to overly simplistic prescriptions) Answer: The primary limitations of portfolio approaches include their oversimplification, often relying on just two dimensions that may not capture complex realities. They can overlook potential synergies between business units and become overly mechanical, focusing more on rigid criteria than strategic insight. The approach may also enforce overly strict rules for resource allocation, and the imagery used can lead to simplistic, one-size-fits-all recommendations that fail to address nuanced or dynamic market conditions. We close out the section with the example of how one company, Cabot Corporation, experienced erosion in its market position when it “blindly” adopted the portfolio approach. C. Caveat: Is Risk Reduction a Viable Goal of Diversification? In this section we briefly address the issue as to whether or not diversification should be undertaken in order to reduce risk that is inherent in a firm’s variability in revenues and profits over time. While it may make sense at “first glance,” there are some limitations to such an approach. First, a firm’s stockholders can diversify their portfolio at much lower cost than a corporation. And, second, economic cycles as well as their impact on a given industry (or firm) are very difficult to predict with any degree of accuracy. However, such a diversification rationale can, at times, be justified. We discuss how General Electric has benefited from diversification by lowering the variability (or risk) in their performance over time. The SUPPLEMENT below addresses two of the more difficult issues in studying diversification: what really is the difference between related and unrelated diversification? Is it possible to reduce risk even with a related diversification strategy or is conglomerate diversification the only path to risk reduction?  Extra Example: Johnson & Johnson’s Diversification Strategy Is Johnson & Johnson pursuing a strategy of related diversification or conglomerate (unrelated) diversification? Let us see what businesses they are in. J&J is organized into three major product groups: consumer products, medical devices and diagnostics, and pharmaceuticals. The consumer products group sells such well known brands as baby shampoo and oil, Listerine mouth wash, Nicorette anti-smoking gum, and Neutrogena skin care products. The medical diagnostics and devices group includes a wide variety of products such as such as sutures, blood tests, endosurgery tools, and artificial joints. The products of the pharmaceutical group include Concerta for attention deficit disorder, Remicade for arthritis, and Prezista for HIV/AIDS. On the one hand, one can say that all these products are in the health care industry. On the other hand, there is not much in common between shampoo, artificial joints, and arthritis drugs in terms of technology, marketing, or distribution. That is, while J&J is not clearly a conglomerate, the furthest corners of its product empire bear little relatedness. Has this extensive product portfolio helped or hurt J&J? Their experience is that it certainly reduces risk, a benefit that is normally associated with conglomerate diversification. For example, in 2009, two of their key drug patents are expiring but the loss in revenue is substantially offset by the strong growth by medical diagnostics and devices group. Finally, has J&J been able to derive any synergies across their seemingly unrelated products? The answer is an emphatic yes. Collaboration between engineers from the devices group and scientists from the pharma group led to a path breaking discovery: tiny metal stents used to open blocked arteries that are coated with a drug to prevent the artery from narrowing again. Launched in 2002, the drug-eluting Cypher stent has already generated over $10 billion in sales! Source: Colvin, G. & Shambora, J. 2009. J&J: Secrets of success. Fortune. May 4: 118.  Discussion Question 11: Can you contrast J&J’s strategy with that of other companies in the health care industry? What differences stand out? Answer: Johnson & Johnson’s strategy is notable for its broad diversification across pharmaceuticals, medical devices, and consumer health products, which contrasts with other companies in the healthcare industry that may focus more narrowly on specific sectors. J&J's decentralized structure allows its subsidiaries considerable autonomy, fostering innovation and responsiveness. In contrast, companies like Pfizer or Merck are more concentrated on pharmaceuticals and biotechnology, often pursuing a more centralized approach. This strategic difference impacts their market focus, operational flexibility, and risk management. V. The Means to Achieve Diversification In the first three sections of the chapter we addressed the types of diversification (i.e., related and unrelated). Now we address the means to attain diversification. These include: • mergers and acquisitions; • strategic alliances and joint ventures; • internal development. A. Mergers and Acquisitions  Discussion Question 12: What are the major advantages and disadvantages of mergers and acquisitions? Answer: Advantages of mergers and acquisitions include access to new markets, enhanced capabilities, and economies of scale, which can drive growth and increase competitive advantage. They also offer opportunities for synergies, cost savings, and strategic alignment. Disadvantages involve integration challenges, cultural clashes, and the risk of overpaying for the acquired company. Additionally, they can lead to increased debt and disruption to ongoing operations, potentially negating the anticipated benefits. Growth through mergers and acquisitions (M&A) has played a critical role in the success of many corporations in a wide variety of high technology and knowledge-intensive industries. Here, market and technology changes can occur very rapidly and unpredictably. In addition to speed, M&A can also be a valuable means of obtaining resources that can help an organization to expand its product offerings and services. M&A also can help companies enter new market segments. EXHIBIT 6.6 illustrates the enormous volume in global mergers and acquisitions since 2000. While there are ebbs and flows in the level of M&A activity that relate to economic conditions, there are billions of dollars worth of deals every year. The track record of acquisitions is less than stellar as described in the text. There are a number of reasons why acquisitions fail most of the time. However, companies like Cisco have been remarkably successful in their acquisition efforts (their experience with Flip notwithstanding). The SUPPLEMENT below describes Parker Hannifin’s extraordinary track record with acquisitions and the reasons behind their success.  Extra Example: Parker’s Successful M&A Strategy Parker, the Cleveland-based industrial products manufacturer makes an average of ten acquisitions every year. What is truly impressive is not just the number but the remarkable success they have had with these acquisitions. What do they do right? • Parker works very hard to retain the employees of the acquired organization by communicating frequently with employees and implementing an orderly integration process. • The company assigns an “integration manager” to each acquired firm to get to know its employees at all levels and to make sure that they understand Parker’s goals. • They acquire only firms that they understand very well. Acquisition targets are often their former competitors. This way they already know the customers, the markets, and even the margins. • They send a team of supply-chain and sales managers to each acquired firm so that they can share the best practices to get the lowest prices from their suppliers and the highest prices from their customers. • They send an innovation team to acquired companies to help them launch new products. • They make sure that they don’t ram their practices down the throats of acquired firms. Instead, the emphasis is on making the managers of these firms even more successful than before. • If the managers can’t get the results they want, they don’t hesitate to replace them. Source: Hymovitz, C. 2008. In deal-making, keep people in mind. Wall Street Journal. May 12: np.  Discussion Question 13: Do you think the above strategies will work if the acquisitions are in unrelated industries? Answer: Acquisitions in unrelated industries can be riskier and less likely to benefit from synergies compared to those within related sectors. The strategies might not work as effectively due to differences in market dynamics, operational practices, and cultural fit. Unrelated acquisitions often require significant integration efforts and may dilute focus, leading to potential inefficiencies. However, if managed well, they can provide diversification benefits and open new growth opportunities, though this often requires strong strategic oversight and flexibility. 1. Motives and Benefits In this section, we address the potential advantages of mergers and acquisitions. These include: • Obtaining valuable resources that can help an organization to expand it product offerings and services (example: Cisco Systems); • Provide the opportunity for firms to attain the three bases of synergy — leveraging core competencies, sharing activities, and building market power (examples: eBay’s acquisition of GSI Commerce); • Lead to consolidation within an industry and can force other players to merge (example: the airline industry); • Enter new segments (example: Fiat’s acquisition of Chrysler). • One of the problems with acquisitions is that acquirers tend to overpay. Acquisition premiums are often in the range of 30%• 60% in normal times. The SUPPLEMENT below discusses why economic downturns are a good time to make acquisitions.  Extra Example: Parker Continues to Acquire in Down Times In recent years, economic conditions have been very weak across the globe. While the United States moved out of its recession fairly quickly, other countries, especially in Europe, remained mired in recession. For Parker, this spelled opportunity. Parker, a global firm in motion and control technologies, is a serial acquirer, a firm that undertakes acquisitions regularly as a part of its normal business operations. It found the economic turbulence of recent years to provide an opportunity. The economic troubles in a number of countries resulted in significant declines in the market value of potential acquisition targets, increasing their attractiveness as acquisition targets. These troubles have also reduced the number of potential acquiring firms competing with Parker as many firms have shifted their attention to shoring up their own core operations rather than undertaking acquisitions. Parker used this period to acquire a number of companies in geographic regions in which Parker wanted to grow. For example, in 2012, Parker acquired a number of firms in India, including PIX Transmissions and John Fowler PLC. Parker also acquired Olaer Group, a British-based firm that manufacturers hydraulic system parts. While this firm is U.K.-based, it sells its products in fourteen countries. These acquisitions allow parker to diversify its product portfolio and geographic reach. By undertaking these acquisitions during a down economic time, Parker is able to achieve its strategic goal to become a broad-based, global player at attractive prices. Source: Anonymous. 2012. Parker completes acquisition of the Olaer Group in the United Kingdom. Prnewswire. July 2: np. Anonymous. 2012. Proactive acquisitions by Parker. Finance.yahoo.com. July 13: np.  Discussion Question 14: The PC industry is going through a massive downturn currently. Do you think this is a good time for leading firms to acquire weaker players? Answer: Acquiring weaker players during a downturn can be strategic for leading firms, offering opportunities to gain market share and acquire valuable assets at lower costs. However, it requires careful evaluation of the target companies' long-term viability and potential for recovery. Risks include integrating struggling businesses and addressing market uncertainties. If managed prudently, such acquisitions can strengthen competitive positioning and enable firms to capitalize on future market upturns. EXHIBIT 6.7 summarizes the potential benefits of M&As. The SUPPLEMENT below presents an interview with eBay’s CEO, John Donahue, who shares insights into how the firm integrates new acquisitions into its organizational culture.  Extra Example: eBay’s Integrating of New Acquisitions in its Organizational Culture With your other acquisitions, what have you learned about how to make them work, how to integrate them into the culture? We think about acquisitions in three categories: acquisitions to strengthen our core, adjacent acquisitions, and capability acquisitions. The easiest are the first kind, like the acquisition two years ago of (the Korean auction site) Gmarket. We’re letting adjacent acquisitions, such as StubHub and Bill Me Later, run relatively independently. With Bill Me Later we’ve integrated core capabilities into PayPal and eBay. Positronic, a small search company, is in the third category. In many cases we’re buying the people--Christopher Payne, who’s running eBay North America now, was a founder of Positronic--which helps us integrate faster and acquire great talent. Source: Ignatius, A. 2011. How eBay developed a culture of experimentation. Harvard Business Review. 89(3): 96.  Discussion Question 15: What benefits would eBay have from allowing an acquired firm, such as Bill Me Later to function relatively independently? Answer: Allowing Bill Me Later to function relatively independently can benefit eBay by preserving the acquired firm's innovative culture and operational expertise. This autonomy can foster innovation, maintain specialized focus, and ensure smoother integration without disrupting the core operations of eBay. It also allows Bill Me Later to continue leveraging its established market presence and relationships, which can enhance overall strategic synergy. Discussion Question 16: Is it a good idea to impose the acquiring firm’s culture onto the acquired firms? Why? Why not? Answer: Imposing the acquiring firm’s culture onto acquired firms can be problematic as it may lead to resistance, decreased morale, and loss of valuable practices from the acquired firm. It is often more effective to blend cultures, acknowledging strengths from both sides to create a cohesive and collaborative environment. A flexible approach to integration respects the acquired firm's existing culture while aligning with the acquiring firm’s broader objectives. 2. Potential Limitations Here, we discuss some of the possible drawbacks of mergers and acquisitions. These include: • The takeover premium can be very high (examples: Household International’s acquisition of Beneficial an 83 percent premium; and, Conseco paid an 82 percent premium to acquire Green Tree Financial); • Competing firms can often imitate any advantages realized or copy synergies that result from the M&A; • Managers’ credibility and ego can sometimes get in the way of sound business decisions; • Cultural issues can doom the intended benefits from M&A endeavors (example: merger between SmithKline and Beecham Group). The SUPPLEMENT below addresses the danger associated with being too quick to get rid of key employees, such as the founding entrepreneur, during an M&A transition.  Extra Example: Retaining Key Employees Helps Retain Shareholder Value Mergers & acquisitions have a terrible reputation for destroying shareholder value. David Harding, who runs the M&A practice at management consultant Bain & Co, thinks he knows why. It occurs because, too often, acquiring firms regard the entrepreneurs who started the firm being acquired to be liabilities rather than assets. According to Harding, the opposite is often true and acquirers need to pay more attention to “human due diligence” in the transition between owners. Although such a perspective may seem obvious, a Bain survey of 40 recent deals revealed that only about half of the acquirers paid attention to this factor. Harding recommends identifying key employees early and moving quickly to retain them. One place where this worked was with General Mills acquisition of Small Planet Foods, a Washington State-based organic food company. General Mills allowed the founding entrepreneur, Gene Kahn, to keep running the business as if it was still an independent company. “They gave me a lot of leeway to explore the synergies on my own, rather than be rushed into them,” says Kahn. Kahn stayed on as president of the division for three years after the acquisition and later moved into the vice president of sustainable development for General Mills. The strategy seems to have worked. The Small Planet division has grown from a $60 million to a $250 million dollar business since it was acquired by General Mills. Source: Birger, J. 2007. Entrepreneurs inside the machine. Fortune, May 14: 22; http://www.generalmills.com/Company/Businesses/US_Retail.aspx. EXHIBIT 6.8 summarizes the potential limitations of M&As. STRATEGY SPOTLIGHT 6.3 notes that most acquisitions destroy shareholder value and goes on to discuss when investors tend see value in acquisitions. 3. Divestment: The Other Side of the “M&A Coin” Corporate managers often find it necessary to divest businesses from their portfolios. Divesting can enhance a firm’s competitive position by reducing costs, freeing up resources, enabling management to focus on core business activities, and raising cash to fund existing businesses. We also draw on research by the Boston Consulting Group to identify seven principles for successful divestitures. STRATEGY SPOTLIGHT 6.4 addresses why Tyco International sold a majority stake in one of its businesses, to help finance a share buy back program and Tyco felt they could get a better price on the remaining portion of the business later on. B. Strategic Alliances and Joint Ventures  Discussion Question 17: What are the major advantages and limitations of strategic alliances and joint ventures? Answer: Strategic alliances and joint ventures are assuming an increasingly prominent role in the strategy of leading firms, both large and small. Such cooperative relationships have many potential advantages. Among these are (our text examples are included): 1. Entry into new markets (the partnership of Zara’s alliance with Tata to enter the Indian market); 3. Reducing manufacturing (or other) costs in the value chain (the combination of SABMiller’s and Molson Coors’ brewing operations); 3. Developing and diffusing new technologies (Verizon Wireless and ILS Technology). STRATEGY SPOTLIGHT 6.5 discusses how an advertising and animation firm formed a strategic alliance to generate revenue and profits for both firms. There are also many potential limitations associated with strategic alliances and joint ventures. Problems often arise when there are not complementary strengths, limited opportunities for developing synergies, low trust among the partners, and minimal attention given to nurturing close working relationships. The SUPPLEMENT below addresses some useful tips for making partnerships work.  Extra Example: Tips for Making Partnerships Work Here is what some experts advise for successful partnerships: 1. Demonstrate the value of your partnership to gain your partner’s confidence. Your partner will then be much more open to your ideas. 2. Establish rules of engagement with your partner, including boundaries and responsibilities, early. 3. Focus on your partner’s best interests. Avoid becoming too revenue-focused when partnering. 4. Find partners with skills that complement — not rival — your own. 5. Respect your partners. 6. Watch out for hidden agendas, such as a partner looking to tap into your expertise so it can get an upper hand going forward. 7. If the cultural shoe fits, wear it. Find partners with perspective and methodologies that mirror your own. Source: Cirillo, R. 2000. Joining forces. VARBusiness. October 2: 52-53.  Discussion Question 18: What would be some of the negative consequences if these “tips” were not followed? Answer: If the "tips" for successful strategic alliances and joint ventures are not followed, negative consequences can include misalignment of goals leading to conflict and inefficiency. There may be increased risk due to poor integration and communication issues, resulting in wasted resources and missed opportunities. Additionally, failing to manage dependencies can harm performance and innovation, while unresolved conflicts might damage relationships and reputations, undermining the overall success of the alliance. C. Internal Development Firms can also diversify via corporate entrepreneurship and new venture development. In today’s economy, internal development (or intrapreneurship) is such an important topic by which companies expand their businesses that we dedicate a major portion of an entire chapter to it (Chapter 12 — which also addresses corporate entrepreneurship). Among the advantages of internal development is the ability to capture all of the value of innovative endeavors (as opposed to sharing with partners). Generally firms may be able to accomplish it at a lower cost than relying on external funding. There are also potential disadvantages such as the time consuming nature of intrapreneurship — which is particularly important in fast-changing competitive environments.  Discussion Question 19: How can internal development endeavors be made more effective? Answer: To make internal development endeavors more effective, companies should foster a culture of innovation and provide clear strategic direction aligned with business goals. Investing in employee training and development can enhance skills and capabilities. Implementing robust project management practices and leveraging cross-functional teams can improve execution and collaboration. Additionally, regularly reviewing progress and adapting strategies based on feedback and market changes can ensure continuous improvement and alignment with evolving objectives. VI. How Managerial Motives Can Erode Value Creation In this section, we address some of the managerial motives that can erode, rather than enhance, value creation. These include “growth for growth’s sake”, excessive egotism, and the creation of a wide variety of anti-takeover tactics. A. Growth for Growth’s Sake There are huge incentives for executives to grow the size of the firm. These include extra prestige (such as higher rankings in the Fortune 500) and compensation as well as the excitement that is generated by making the “big play.” We provide the examples of Priceline.com’s entry into offering groceries and gasoline online, and how Joseph Bernardino’s overemphasis on growth at Andersen Worldwide played a key role in the firm’s demise. Both of these efforts of growth had negative implications for their firms’ viability. B. Egotism As we all know, a healthy ego makes a leader more confident and able to cope with change. However, sometimes pride is at stake, and individuals will go to great lengths to win — or at least not back down. Such behavior is often detrimental to the firm. We provide several examples of rather hostile interactions among executives after their merger. Such clashes can certainly lead to the erosion of some of the intended benefits of diversification. We also discuss “lessons learned” by GE’s Jack Welch — situations in which ego got in the way of better judgment. We also discuss how egotism (as well as very poor judgment!) led to the demise of Tyco International’s Dennis Kozlowski and Merrill Lynch’s John Thain. The SUPPLEMENT below discusses how egotism caused Mattel to fail miserably with an acquisition.  Extra Example: Mattel Falls Prey to Egotism with the Learning Company In 1999, Mattel found itself in a difficult situation. Its growth was slowing, its flagship product, Barbie, was losing market share, and it did not have a strong position in computer-based games. Mattel CEO, Jill Barad, thought that the solution was for Mattel to shift its attention to the faster growing computer-based interactive games market. To move aggressively in this market, she decided to acquire the Learning Company, a maker of interactive and educational games. The price was steep• $3.5 billion which was 4.5 times the Learning Company’s annual revenue. It turned out to be a very expensive move. Mattel found that the Learning Company was generating little free cash flow and had a stable of aging brands. To make matters worse, Mattel didn’t have the skills to renew the product portfolio of the Learning Company. Mattel lost two-thirds of its market value after the acquisition. Jill Barad lost her job. And the Learning Company was sold off for a paltry $27 million. One of the key mistakes with this acquisition was that Mattel was over-confident in its ability to run the Learning Company. They thought that their managerial talent and knowledge could be easily transferred to run the Learning Company. What they found, instead, was that the skills needed to run a computer software company were very different than those needed to run a toy company. Also, they had little appreciation for the differences in the market dynamics of the software business. Mattel would have been much better served by focusing their attention on being the strongest competitor possible in their core market, a market where they should have had the competencies needed to build a competitive advantage. Source: Hirsch, E. & Rangan, K. 2013. The grass isn’t greener. Harvard Business Review. 91(1): 21-23.  Discussion Question 20: How can such egotistic behavior be minimized? (e.g., reward and control systems, executive selection, culture, etc.) Answer: Egotistic behavior can be minimized by implementing balanced reward and control systems that emphasize team achievements and collective goals over individual accolades. Effective executive selection should focus on candidates with demonstrated humility and collaborative skills. Cultivating a company culture that values transparency, feedback, and inclusivity can also reduce egotism by promoting shared success and accountability. Regular performance reviews and leadership training can further reinforce these values and mitigate self-serving tendencies. C. Anti-Takeover Tactics Anti-takeover tactics are rather common. These are efforts by management to prevent hostile or unfriendly takeovers by unwelcome suitors. Often, it is in management’s best interests to undertake such actions — but typically not in the interests of the firm’s shareholders. We discuss three types of anti-takeover tactics: greenmail, golden parachutes, and poison pill. Teaching Tip: Ask the students how the managerial behaviors that erode shareholder value can be minimized. This provides you with an opportunity to reintroduce the underlying concepts of corporate governance that we introduced in Chapter 1 and will be discussed at length in Chapter 9. The core elements of corporate governance are a committed and well-informed board of directors, shareholder activism, and effective incentive and reward systems for executive officers. STRATEGY SPOTLIGHT 6.6 addresses how antitakeover measures can benefit multiple stakeholders – not just management. Note: This would likely be an interesting counterintuitive issue to address.  Discussion Question 21: Can you provide other examples (either real or hypothetical) of how antitakeover measures may benefit multiple stakeholders? Answer: Antitakeover measures can benefit multiple stakeholders in various ways. For example, poison pills can deter hostile takeovers, ensuring that employees retain job security and benefit from stable working conditions. Golden parachutes offer executives financial protection, maintaining leadership stability during transitions. Staggered boards can prevent sudden disruptions, protecting long-term shareholders and giving time for strategic adjustments. Overall, these measures can help safeguard the interests of employees, management, and investors by fostering a more stable and predictable business environment. I VII. Issue for Debate The case examines Delta Airlines’ decision to acquire a petroleum refinery. This acquisition is a form of vertical integration since jet fuel is a high-cost product that is a necessary component to run an airline. For Delta, jet fuel makes up 36 percent of its operating expenses.  Discussion Question 22: Does it make sense for Delta to purchase a refinery? Answer: On the one hand, this could be seen as a relatively low cost but potentially beneficial action to cut costs for Delta. The acquisition of the refinery was relatively low cost, only $150 million for the purchase and up to $200 million to upgrade the facility. Delta spends about $12 billion a year in fuel. If they are able to shave 2 percent off their fuel cost by refining it themselves, they will recoup the cost of the purchase and upgrades in less than two years. They will then save themselves more than $200 million a year in operating costs. However, the refining business is a very different business than the airline industry. Delta does not have the requisite competencies to run an oil refinery. Thus, they will have to hire the right personnel and cultivate the capabilities to run the refinery. They may have fallen prey to egotism with this purchase. Also, since they are a small player in the market for oil, they will have very little buyer power relative to oil producers. If they are slightly less efficient in their operations than other refineries, they will find this to be a very expensive business. Recently, the return on sales in this business has been about 2 percent. Thus, if Delta runs the refinery at a level that is 5 percent less efficient than competing refineries, they will end up paying about $350 million more for fuel from their own refinery than they would have if they had purchased it on the open market.  Discussion Question 23: What are the risks and benefits of this vertical integration strategy? Answer: The primary benefits are control over the supply of jet fuel and the ability to buy fuel at cost (not paying refiner markup). The primary risks are that they may be inefficient since they have no experience in the refining business. Also, they may face losses since refining is an economically unattractive business. Finally, they may be locked in with certain suppliers since this refinery is most suited to refine oil from the North Sea oilfields.  Discussion Question 24: Could there have been another option for Delta to lock in their fuel at a more favorable cost? Answer: Yes, their major desire is to minimize the cost they have for fuel. There are at least two other ways they could have achieved that. First, they could have used option contracts to purchase the right to buy fuel at a preset price in the future. In times when the price of fuel rises, they could exercise the contracts and buy fuel at the option contract price. In times when the price of fuel declines, they can choose to not exercise the contracts, and instead, buy the necessary fuel at market prices. This has been a common practice of Southwest Airlines and was a major driver of their ability to stay profitable when fuel prices spiked a few years ago. Second, they could set up a strategic alliance with a refiner that involves a long term contract for jet fuel. They could use this contract to preset the price they will pay for fuel or negotiate a floating rate where they agree to purchase the fuel at a slight discount to market prices. Refiners may agree to such a deal to guarantee demand for their refined fuel. This could also involve having the refiner tweak the refinery to produce jet fuel at a higher rate as Delta is doing with the Trainer refinery in order to more efficiently produce jet fuel.  VIII. Reflecting on Career Implications Below, we provide some suggestions on how you can lead the discussion on the career implications for the material in Chapter 6.  Corporate-Level Strategy: Is your current employer a single business firm or a diversified firm? If it is diversified, does it pursue related or unrelated diversification? Does its diversification provide you with career opportunities, especially lateral moves? What organizational policies are in place to either encourage or discourage you from moving from one business unit to another? Very often students are so far removed from the corporate level of their organizations; many of them will have only very vague notions about their firm’s corporate strategy. This would be a good opportunity to make them think about corporate strategy and how that relates to the career options they have.  Core Competencies: What do you see as your core competencies? How can you leverage them both within your business unit as well as across other business units? It would be a good idea for the instructor to make connection to the personal SWOT that the students performed earlier. The challenge is to make each individual think in terms of their core competency. Once they have identified their core competency, the discussion can move on to how that competency can be leveraged. This part is sometimes tricky because a student may identify his/her musical or artistic skill as their core competency. At that point, either the instructor can ask them, if indeed that is the case, why they did not leverage that in their life or instead ask them to identify their core competency strictly within their professional context.  Sharing Infrastructures: Identify what infrastructure activities and resources (e.g., information systems, legal, training) are available in the corporate office that is shared by various business units in the firm. How often do you take advantage of these shared resources? Identify ways in which you can enhance your performance taking advantage of these shared infrastructures resources. Students will rarely have a good handle on this issue. The key point to make is that employees can enhance and demonstrate their value to their firms by leveraging the value enhancing possibilities of the corporate office. It also may help employees build their social networks by coordinating actions with corporate officers and employees and managers in different units in the firm.  Diversification: From your career perspective, what actions can you take to diversify your employment risk (e.g., coursework at a local university, obtain professional certification such as a C.P.A., networking through professional affiliation, etc.)? In periods of retrenchment, such actions will provide you with a greater number of career options. While students can often easily talk of risk in terms of a financial portfolio, they have difficulty identifying and evaluating risk in the context of their own employment. The key is to make them see the parallels between investment decisions and employment choices. That is, they are investing their time, effort, and money in building human capital. Although they have thought about the returns from that investment, most have never recognized the need to diversify the employment risk. This could lead to a lively discussion.  IX. Summary A key challenge of today’s managers is to create “synergy” when engaging in diversification activities. As we discussed in this chapter, corporate managers do not, in general, have a very good track record in creating value in such endeavors when it comes to mergers and acquisitions. Among the factors that serve to erode shareholder values are paying an excessive premium for the target firm, failing to integrate the activities of the newly acquired businesses into the corporate family, and undertaking diversification initiatives that are too easily imitated by the competition. We addressed two major types of corporate-level strategy: related and unrelated diversification. With related diversification the corporation strives to enter into areas in which key resources and capabilities of the corporation can be shared and leveraged. Synergies come from horizontal relationships among business units. Cost savings and enhanced revenues can be derived from two major sources. First, economies of scope can be achieved from the leveraging of core competencies and sharing of activities. Second, market power can be attained from greater, or pooled, negotiating power and from vertical integration. When firms undergo unrelated diversification they enter product-markets that are dissimilar to their present businesses. Thus, there is generally little opportunity to either leverage core competencies or share activities across business units. Here, synergies are created from vertical relationships between the corporate office and the individual business units. With unrelated diversification, the primary ways to create value are corporate restructuring and parenting, as well as the use of portfolio analysis techniques. Corporations have three primary means of diversifying their product-markets. These are mergers and acquisitions, joint ventures/strategic alliances, and internal development. There are key tradeoffs associated with each of these. For example, mergers and acquisitions are typically the quickest means to enter new markets and provide the corporation with a high level of control over the acquired business. However, with the expensive premiums that often need to be paid to shareholders of the target firm and the challenges associated with integrating acquisitions, they can also be quite expensive. Strategic alliances among two or more firms, on the other hand, may be a means of reducing risk since they involve the sharing and combining of resources. But such joint initiatives also provide a firm with less control (than it would have with an acquisition) since governance is shared between two independent entities. Also, there is a limit to the potential “upside” for each partner because returns must be shared as well. Finally, with internal development, a firm is able to capture all of the value from its initiatives (as opposed to sharing it with a merger or alliance partner). However, diversification by means of internal development can be very time-consuming — a disadvantage that becomes even more important in fast-paced competitive environments. Finally, some managerial behaviors may serve to erode shareholder returns. Among these are “growth for growth’s sake,” egotism, and anti-takeover tactics. As we discussed, some of these issues —particularly anti-takeover tactics — raise ethical considerations because the managers of the firm are often not acting in the best interests of the shareholders. Chapter 6: Corporate-Level Strategy: Creating Value Through Diversification For a company with which you are familiar, select a potential area of diversification. Provide supporting arguments for this diversification move (e.g., if it is related diversification it might involve leveraging core competences or sharing activities). Would you recommend internal development, strategic alliances/joint ventures, or acquisition as the means to achieve this diversification? Clarify your rationale. Teaching Suggestions: Key points to be highlighted in this exercise are: *What businesses should a corporation compete in? How can a corporation create ‘synergy’ among the various business units? You can discuss the merits and demerits of related vs. unrelated diversification. (Refer students to Exhibit 6.2 on page xxx which both the means to achieve related and unrelated diversification as well as examples from business practice.) -• Related diversification: -• Synergies are realized from the horizontal relationships among businesses. Firm creates economies of scale and scope by leveraging core competencies and sharing activities You might want to explain the concepts of ‘core competencies’ and ‘economies of scope’ here. -• Synergies are also realized from market power through pooled negotiating power and vertical integration. Here you can raise questions related to the merits and demerits of vertical integration and introduce the ‘transaction costs perspective’ which is very important in vertical integration decisions. You must also mention that creating market power would draw the attention of regulatory authorities and therefore there are limits on creating and using market power. --Unrelated diversification: -Creates value by exploiting vertical relationships. -Corporate office can add tremendous value in terms of parenting and restructuring the businesses. -Corporate office can add value by viewing the corporation as a family or ‘portfolio’ of businesses and allocating resources to optimize corporate goals and profitability. Value can also be added by creating appropriate support structure in terms of human resource practices and financial controls for each of its business units. *Should a corporation necessarily diversify? Which method of diversification should a firm employ? Profit maximization as a goal propels a firm to grow and diversification becomes a means of achieving such growth. However, diversification, whether related or unrelated, comes with its own problems and therefore raises the question of whether a firm needs to diversify at all. You might want to give examples of some diversification efforts that failed. You can then discuss whether internal development i.e., through corporate entrepreneurship and new venture development is better than external growth through mergers & acquisitions or strategic alliances and joint ventures. This gives the opportunity to discuss the merits and demerits of each these methods of diversification. *Does diversification create value at all? A very important question to raise. Research shows that diversification destroys rather than create value. Then, why do firms pursue a diversification strategy? The issue of incentive structure in the U.S. corporations that rewards CEOs on the size of the firm rather than its profitability and shareholder wealth maximization needs to be discussed. You might also want to mention that egotism and anti-takeover tactics take CEOs to any lengths to protect their ‘turfs.’ They may engage in diversification that does not create any value for the shareholders at all and instead, destroys shareholder value. You can raise these questions regardless of the method of diversification the students come up with. This discussion will develop their ability to think critically about issues involved in diversification decisions. End of Chapter Teaching Notes Chapter 6: Corporate-Level Strategy: Creating Value through Diversification Summary Review Questions 1. Discuss how managers can create value for their firm through diversification efforts. Response: Diversification is often more costly for firms to do than for investors, so firms are not doing their shareholders a favor if they diversify without creating new value. Managers can create new value by combining their operations with the new business in a way that increases the diversified firm’s value relative to the combined value of the pre-diversified firm(s). The two primary methods for creating value are lowering costs and increasing revenue. For lowering costs, firms are able to operate in multiple businesses and generate a given level of total revenue more efficiently than would be the case if there were separate firms in each business. These lower costs are due to a number of factors including economies of scale, leveraging core competence, sahred activities, and/or vertical integration. For increasing revenue, diversified firms are able to generate more revenue than would be the case if there were separate firms in each business. The increased revenue can be due to processes such as pooled negotiating power and possibly vertical integration. Answer: Managers can create value through diversification by leveraging synergies between business units to achieve cost savings and operational efficiencies. They can also tap into new markets and revenue streams, spreading risk and enhancing overall growth potential for the firm. 2. What are some of the reasons that many diversification efforts fail to achieve desired outcomes? Response: Managers of diversification efforts often fail to do the very difficult job of effectively combining operations in different businesses. According to the text diversifiers: • “failed to effectively integrate their acquisitions“ • “paid too high a premium for the target’s common stock” • “were unable to understand how the acquired firm’s assets would fit wit their own lines of business” • had top executives who “may not have acted in the best interests of shareholders. That is, the motive for the acquisition may have been to enhance the executives’ power and prestige rather than to improve shareholder returns.” Answer: Many diversification efforts fail due to a lack of alignment between new ventures and the firm's core competencies, leading to integration challenges and operational inefficiencies. Additionally, inadequate market research and overestimation of potential synergies can undermine the success of diversification strategies. 3. How can companies benefit from related diversification? Unrelated diversification? What are some of the key concepts that can explain such success? Response: Related diversification is a firm entering a different business in which it can benefit from leveraging core competencies, sharing activities, or building market power. Companies can benefit from related diversification through economies of scope (leveraging core competencies or sharing related activities among businesses), or market power. Market power can be exercised through pooled negotiating power, where a diversified firm can restrict or control supply to a market, or vertical integration into the buyer or supplier industry. Vertical integration enables a firm to have secure access to strategic inputs and to gain efficiencies through coordinating delivery of inputs and outputs. Unrelated diversification is a firm entering a business that uses different core competencies and operates in different markets. Companies can benefit from unrelated diversification by improving the target businesses. Two ways to improve these businesses are parenting, where the company will provide expertise and support such as improving planning, budgeting, management performance evaluation and procurement practices. The second way to improve the target business is through restructuring, which involves substantially changing the assets, capital structure, and/or management. Portfolio management is a method of assessing a corporation’s entire portfolio of businesses, and helps managers to determine the strategic options and contribution of each business to the corporate overall performance. For corporations with multiple unrelated businesses, portfolio management helps to develop restructuring strategies. Answer: Companies benefit from related diversification by leveraging synergies and shared resources across similar industries, enhancing operational efficiencies and market presence. Unrelated diversification offers risk reduction and potential financial gains from new revenue streams, with success often driven by strategic management and resource allocation expertise. 4. What are some of the important ways in which a firm can restructure a business? Response: Three types of restructuring are asset restructuring, capital restructuring, and management restructuring. Asset restructuring involves selling off unproductive assets and product lines and acquiring complementary assets needed to improve the business. Capital restructuring involves improving the debt/ equity ratio, adding different classes of debt and equity. Management restructuring involves changing the composition of top management and the firm’s organization, as well as changes to the reporting relationships and management performance evaluation criteria. Answer: A firm can restructure a business by divesting non-core assets to focus on strategic areas and reorganizing its operational structure to improve efficiency and adaptability. Implementing these changes can streamline operations and enhance overall performance. 5. Discuss some of the various means that firms can use to diversify. What are the pros and cons associated with each of these? Response: Firms can diversify using mergers and acquisitions, strategic alliances and joint ventures, or internal development. Mergers and acquisitions involve joining two separate firms into one. Mergers and acquisitions enable firms to fully integrate operations; acquire valuable resources and exploit them through leveraging core competencies, sharing activities, and building market power; consolidate the industry, and enter new market segments. The cons of mergers and acquisitions include the financial costs of the diversification, which is especially true for acquisitions. The resulting benefits be easily be imitated by the competition. Managers’ credibility may be associated with mergers and acquisitions, which may result in escalating commitment to making the diversification work and thereby sub optimal decision-making. And mergers and acquisitions involve the combination of two corporate cultures, which may lead to issues that are costly to resolve. Strategic alliances and joint ventures are a method of diversification that involves collaboration with partner firms. They are a method of gaining the advantages of mergers and acquisitions without the financial costs. The benefits of strategic alliances and joint ventures are that they enable firms to achieve strategic objectives such as entering new markets, reducing manufacturing (or other) costs in the value chain, and developing and diffusing new technologies. The cons of strategic alliances and joint ventures include working with a partner that is unwilling or unable to invest adequate resources to achieve the objectives, the necessary investment in nurturing close working relationships with partner executives, and the investment in human and social capital needed to forge a successful partnership. Internal development is another way for firms to diversify, through corporate entrepreneurship. Internal development enables firms to achieve the benefits of mergers and acquisitions without the financial cost premium or the costs of combining two corporate cultures. The cons of internal development include the potential time lag to enter the new business. Answer: Firms can diversify through acquisitions, which offer quick market entry but can lead to integration challenges, or internal development, which allows for controlled growth but may be slower and require significant resources. Joint ventures provide shared risks and expertise but can lead to conflicts, while strategic alliances offer flexibility but might result in less control over outcomes. 6. Discuss some of the actions that managers may engage in to erode shareholder value. Response: Managers have engaged in diversification efforts that do not increase shareholder value. They place their own self-interest ahead of shareholders’. The actions that managers may take can be in the form of growth for growth’s sake, egotism, and antitakeover tactics. Growth for growth’s sake results from managers’ desires to work in larger, more powerful organizations, which offer more challenges, excitement, recognition, power, and prestige to their managers. Egotism refers to managers’ self-interest and greed. Managers’ competitive nature may lead them to acquire businesses for personal satisfaction. Related to egotism is the personal largesse of some executives. Antitakeover tactics include greenmail, golden parachutes, and poison pills. These tactics can erode shareholder value, especially for existing shareholders, by either making a large payment to a potential acquirer (greenmail), making a large payment to executives (golden parachutes), or reducing share price through dilution (poison pills). Each of these diverts value from shareholders to other parties. Answer: Managers may erode shareholder value by pursuing poorly aligned acquisitions that lack strategic fit, or engaging in excessive spending on non-essential projects, which diverts resources from core business activities and reduces overall profitability. Application Questions Exercises 1. What were some of the largest mergers and acquisitions over the last two years? What was the rationale for these actions? Do you think they will be successful? Explain. Response: (Note to instructor) The Wall Street Journal announces mergers and acquisitions on a regular basis. A quick Internet search yields a bunch of mergers as announced by UPI, Reuters, and the like. There has been an ongoing wave of mergers in the banking industry. So getting information from that source should be a straightforward exercise. As for the rationale, ask students to identify a shared core competence, shared activity, enhanced negotiating power, or vertical integration that characterizes the merger or acquisition. If so, then it is a related diversification. The characteristic identified above will indicate the potential benefits of the diversification. Then ask students to estimate the likely costs of the merger or acquisition, including the financial cost to the acquiring firm, and compare that to the benefits. We have found it useful to refer back to the potential for imitation and the other 3 sources of sustainable competitive advantage (rare, valuable, costly to imitate, and costly to substitute). Are these advantages of diversification sustainable? If there is no identified shared core competence, shared activity, enhanced negotiating power, or vertical integration, then the merger or acquisition is unrelated. Ask students to identify the likely benefits from corporate parenting or restructuring. For this, students could look at the recent financial performance of the acquired firm relative to the industry averages. In addition, you can ask students to examine to portfolio of businesses of the acquired firm and conduct a portfolio analysis. Answer: Recent large mergers include Microsoft's acquisition of Activision Blizzard and Amazon's acquisition of MGM. The rationale behind these deals was to enhance market share and expand into new areas—gaming for Microsoft and content for Amazon. Their success will depend on effective integration and achieving strategic goals such as market expansion and revenue growth. 2. Discuss some examples from business practice in which an executive’s actions appear to be in his or her self-interest rather than the corporation’s well-being. Response: (Note to instructor) The business sections of most major newspapers are full of examples of executives who are greedy and in legal trouble. In addition, some students are likely to be aware of business practices in their own experience. For each identified instance, we suggest that you ask the student to describe the questionable practice and classify it as growth for growth’s sake, egotism, antitakeover tactics. Also, identify the groups or individuals who are hurt by the executive(s). To extend the exercise, ask students if there are any modifications to corporate governance and the legal system that would limit the damage from the executives’ actions. Answer: Examples include executives awarding themselves substantial bonuses or stock options despite poor company performance, or pursuing personal pet projects that do not align with the company’s strategic goals, potentially prioritizing personal gain over shareholder value and corporate health. 3. Discuss some of the challenges that managers must overcome in making strategic alliances successful. What are some strategic alliances with which you are familiar? Were they successful or not? Explain. Response: Strategic alliances involve a number of processes, including agreement on goals of the alliance, agreement on the investment or contribution that each partner gives, agreement on the distribution of benefits and learning that the alliance generates, and agreement on a system for monitoring partners’ efforts. As strategic alliances evolve and conflicts arise, these processes may have to be renegotiated between senior managers. The success of a strategic alliance is also not obvious. Strategic alliances are not all supposed to last a long time. It may be possible for an alliance to fulfill its objectives fairly quickly and then be dissolved. Also, some alliances are successful for one partner and not the other. (Note to instructors) Students will usually be aware of the agreements for goals, investments, and distribution of earnings. But they will tend to be less aware of the need for monitoring. To prompt them, try asking about how one partner knows that the other is making sufficient investments in the alliance. In the cases where an alliance is successful for one partner but not the other, ask students how a partner can avoid this outcome. Often, the answer involves partners developing a capacity to learn from the alliance. Answer: Managers must overcome challenges such as cultural differences, alignment of goals, and integration issues to make strategic alliances successful. For instance, the Starbucks and PepsiCo alliance to distribute Starbucks products globally has been successful, leveraging PepsiCo's distribution expertise to enhance market reach and operational efficiency. 4. Use the Internet and select a company that has recently undertaken diversification into new product markets. What do you feel were some of the reasons for this diversification (e.g., leveraging core competencies, sharing infrastructures)? Response: (Note to instructors) Students should be able to identify the core competency or shared infrastructure. Ask students to identify the likely costs and benefits of the diversification in order to determine how successful it was. In addition, ask students what other products or markets the firm should diversify into in the future. Answer: Amazon's recent diversification into healthcare with its acquisition of One Medical aims to leverage its existing technology and distribution infrastructure to enhance its customer service and expand its market presence. The move capitalizes on its core competencies in logistics and data management to innovate in the healthcare sector. Ethics Questions 1. In recent years there has been a rash of corporate downsizing and layoffs. Do you feel that such actions raise ethical considerations? Why or why not? Response: Relevant ethical considerations might include whether the individuals laid off were treated fairly, and whether management acted to maximize firm value. At the individual level, the question would be whether those laid off receive adequate severance, training, and other services to help with the transition to a new job. Note that the ethical obligation to those laid-off individuals may differ from the legal requirement. At the corporate level, the question revolves around the restructuring effort. Effective strategies of unrelated diversification and then restructuring will result in a new business unit that is worth more than the cost of acquisition. If so, then we can infer that managers acted in the best interests of shareholders. If not, then we can suspect that managers acted in self-interest. Answer: Yes, corporate downsizing and layoffs raise ethical considerations as they impact employees' livelihoods and job security. The decisions can be seen as prioritizing financial performance over the well-being of workers, leading to potential moral and social implications. 2. What are some of the ethical issues that arise when managers act in a manner that is counter to their firm’s best interests? What are the long-term implications for both the firms and the managers themselves? Response: Managers have an obligation to their shareholders or, more broadly, their stakeholders. To the extent that managers neglect stakeholders and make business decisions that serve their self-interest, they are behaving unethically. In the chapter, we reviewed such behavior and classified three types as growth for growth’s sake, egotism, and antitakeover tactics. These activities tend to reduce firm value, especially shareholder value, while protecting the interests of managers. The long-term implications for the firm are that firm value is reduced. The ability of the firm to compete effectively and otherwise fulfill its corporate mission are likely to be eroded. And if a firm has managers who conducted a diversification for reasons of self-interest, and those managers were not held accountable, then it is likely that such tactics will be repeated. As a result, firm value will be further eroded. As for the managers themselves, there are two possibilities. One is that the managers will stay with their firms. In this case, the managers may continue to make diversification decisions that erode firm value. In a classical agency problem situation, the managers may be appropriating shareholder value. Two is that the managers will leave their firms, such as through a golden parachute. While these managers will receive a payoff, they are not likely to ascend to the stature they previously had. Of course there are exceptions. Managers who diversify in self-interest once may not repeat the act. They may also be held accountable either by their board, the shareholders, the press, or through legal action. It is not likely that any manager who has faced serious censure will return to the stature he or she enjoyed. Answer: When managers act against their firm's best interests, ethical issues include conflicts of interest, misallocation of resources, and loss of stakeholder trust. Long-term implications can include diminished firm performance, legal repercussions, and reputational damage for both the firm and the managers, potentially leading to career setbacks. Experiential Exercise Time Warner is a firm that follows a strategy of related diversification. Evaluate its success (or lack thereof) with regard to how well it has: (1) built on core competencies, (2) shared infrastructures, and (3) increased market power. (Fill answers in table below.) Response: Time Warner is a well-diversified firm in the entertainment and publishing businesses. Its divisions include Time Inc., Home Box Office, Turner Broadcasting System, the CW network, New Line Cinema, and Warner Bros. Entertainment. It also owns online brands affiliated with its operations such as CNN.com and HBO.com. For the table below, we provide some quick notes on these diversifications. Rationale for Related Diversification Successful/ Unsuccessful? Why? 1. Build on core competencies Successful Competence in television and movie production can be leveraged across all it’s broadcasting activities. 2. Share infrastructures Successful Possible sharing of program production infrastructure across all channels. Sharing of technology across all websites. Sharing of internal systems such as HR and investment analysis across all divisions. 3. Increase market power Successful Bargaining with advertisers regarding airing commercials on multiple channels in multiple media. Increased bargaining power with content providers, as content can be put in multiple formats. (Note to instructor) Students should be able to come up with a number of examples of Time-Warner’s diversifications into new businesses. We suggest you take one at a time and ask students to demonstrate how it has contributed to shareholder value. For the first method – build on core competencies• ask students to first identify the core competence. This question will often be a challenge, as core competencies are complex and abstract, and therefore difficult to articulate. But it is important to do so. Then ask students to argue how this core competence is used for the new business. For the second method – shared infrastructure – ask students to identify the infrastructures. For the third method – increased market power – ask students to identify the type of market power, such as bargaining power or vertical integration. Finally, ask students to evaluate the cost of the diversification and to argue whether the benefits exceed the costs. We suggest that you ask students to defend their diversification decision to a room full of shareholders. In addition to diversification, the case of Time-Warner offers the opportunity to examine the spin-off of AOL. Ask students which of the downsides of the acquisition led to the divestment. Answer: • Time Warner's diversification into media and entertainment leveraged its core competencies in content creation and distribution. This approach helped the company effectively utilize its strengths but faced challenges in integrating new acquisitions. • The company successfully shared infrastructures across its media and entertainment segments, enhancing operational efficiencies and cross-promotion. However, integration complexities occasionally hindered optimal synergy. • Time Warner increased its market power through strategic acquisitions and content control, boosting its competitive position. Yet, regulatory hurdles and integration issues sometimes limited the full realization of these advantages. Solution Manual for Strategic Management: Creating Competitive Advantages Gregory G. Dess, Alan Eisner, G.T. (Tom) Lumpkin, Gerry McNamara 9780077636081, 9781259245558