This Document Contains Chapters 5 to 6 Chapter 5 Competitive Rivalry and Competitive Dynamics LEARNING OBJECTIVES 1. Define competitors, competitive rivalry, competitive behavior, and competitive dynamics. 2. Describe market commonality and resource similarity as the building blocks of a competitor analysis. 3. Explain awareness, motivation, and ability as drivers of competitive behaviors. 4. Discuss factors affecting the likelihood a competitor will take competitive actions. 5. Describe factors affecting the likelihood a competitor will respond to actions taken by its competitors. 6. Explain competitive dynamics in slow-cycle, in fast-cycle, and in standard-cycle markets. CHAPTER OUTLINE Opening Case Tesco PLC: A Case Study in Competitive Behavior Strategic Focus Competitive Rivalry in Fast Fashion: A Constant Stream of Actions and Responses A MODEL OF COMPETITIVE RIVALRY COMPETITOR ANALYSIS Market Commonality Resource Similarity Strategic Focus FedEx and United Parcel Service (UPS): Maintaining Success While Competing Aggressively DRIVERS OF COMPETITIVE BEHAVIOR COMPETITIVE RIVALRY Strategic and Tactical Actions LIKELIHOOD OF ATTACK First-Mover Benefits Organizational Size Quality LIKELIHOOD OF RESPONSE Type of Competitive Action Actor’s Reputation Market Dependence COMPETITIVE DYNAMICS Slow-Cycle Markets Fast-Cycle Markets Standard-Cycle Markets SUMMARY REVIEW QUESTIONS EXPERIENTIAL EXERCISES This Document Contains Chapters 5 to 6 VIDEO CASE LECTURE NOTES Chapter Introduction: The competitive landscape is characterized by increasing globalization, advanced technological development, and other factors that will lead to an environment that is more dynamic and charged with rivalry. Firms will act and react in a dance of sorts, but one involving very high stakes—even survival. This chapter introduces terms and concepts relevant to the conversation about competitive behavior in a variety of markets. Figure 5.2 is central to the discussion of most of the chapter. OPENING CASE Tesco PLC: A Case Study in Competitive Behavior Tesco PLC is the world’s third-largest retailer but, as the Opening Case makes clear, past success is no guarantee of future success. In 2012 it experienced its first profit decline in almost two decades. In 2013 it closed its Fresh & Easy stores in the U.S., wrote down the value of its global operations by $3.5 billion, and experienced declining revenue in its home market (from which approx. two-thirds of sales and profits come). Part of the reason for the revenue issues comes from declining customer perceptions of Tesco’s quality, prices, promotions, and overall value. In response, Tesco is adding more and better-trained staff, refurbishing stores, and revamping product lines and prices. The Opening Case illustrates some concepts introduced in Chapter 5. For example, the response actions noted directly above are considered to be tactical actions, while opening Fresh & Easy stores in the U.S. is considered a strategic action. While the Fresh & Easy action seems reasonable, Tesco introduced the concept without a good understanding of U.S. consumers. As the company continues to try to reposition itself in the industry it is taking addition strategic actions including investing and/or partnering with Harris & Hoole (coffee), Euphorium (bakery), and Gireaffe (restaurant chain). Teaching Note: The opening case illustrates the transitory nature of competitive advantage and how tactical and strategic actions are necessary to produce above-average returns. To ensure that students understand the difference between these concepts, ask them to identify some actions that companies have taken to improve performance. Students should be able to identify a variety of companies from different industries. Ask them to identify whether the actions are strategic or tactical. 1 Define competitors, competitive rivalry, competitive behavior, and competitive dynamics. A strategy’s success is determined not only by the firm’s initial competitive actions, but also by how well it anticipates competitors’ responses to them and by how well the firm responds to its competitor’s initial actions (also called attacks). Some important definitions: • Firms operating in the same market with similar products targeting similar customers are competitors. • Competitive rivalry is the ongoing set of competitive actions and competitive responses occurring between rivals as they compete against each other for an advantageous market position. • Competitive behavior is the set of competitive actions and competitive responses the firm takes to build or defend its competitive advantages and to improve its market position. • Firms competing against each other in several product/geographic markets are in multimarket competition. • All competitive behavior—that is, the total set of actions and responses taken by all firms competing within a market—is called competitive dynamics. Teaching Note: Firms must learn to compete differently if they are to achieve strategic competitiveness. To provide an idea of what this means, new ways of competing may include the following: • Bringing new goods and services to market more quickly • The use of new technologies (e.g., Amazon.com) • Diversifying the product line (e.g., Barnes and Noble into music as a catalyst for growth) • Shifting product emphasis (e.g., U-haul’s focus on accessory sales) • Consolidation (e.g., the merger of Hewlett Packard and Compaq) • Combining online selling with physical stores (e.g., Sears’s acquisition of Lands’ End) The focus of this chapter is on competitive dynamics, the series of competitive actions and competitive responses among firms competing within a particular industry. The implication that should be strongly stated is that the strategic management process (as described in Chapter 1 and Figure 1.1) is dynamic, not static. STRATEGIC FOCUS Competitive Rivalry in Fast Fashion: A Constant Stream of Actions and Responses The Strategic Focus revisits fast fashion company Zara (Opening Case, Chapter 3) and profiles the competitive rivalry that it has with global fast fashion retailer H&M. Zara and H&M compete on some of the same dimensions, such as supply chain, but as resources are idiosyncratic, each companies has unique capabilities. Zara has supply chain advantages that allow it capture catwalk and luxury trends and have products in stores in within weeks. H&M has a longer supply chain which cannot match Zara on speed, but does allow it to aggressively compete on price (offering products that are on average 60 percent cheaper than Zara). Recently H&M (and other retailers) undertook a competitive response to Zara by opening outlets in Mexico (Zara was a first mover in Mexico - 1992). H&M is also initiating a first mover approach in India, to which Zara may need to address. Both companies are also competing online with Zara being the first mover and H&M responding to Zara’s presence by developing its own online presence. Teaching Note: Even casual observers can recognize the high degrees of both market commonality and resource similarity among Zara and H&M. The fast fashion industry is also a good example of an industry characterized by fast market cycles. Ask students to evaluate the potential for sustainable competitive advantage under these conditions. Can firms with high resource similarity truly develop enduring core competencies? Finally, ask students to identify other industries in which the competitors have high degrees of market commonality and resource similarity and how these conditions contribute to the degree of competitive rivalry in these industries. FIGURE 5.1 From Competitors to Competitive Dynamics This figure features the key concepts involved in competitive dynamics, which refers to the total set of actions and responses taken by all of the firms competing in a given market. Expanding geographic scope contributes to the increasing intensity in competitive rivalry among firms. That is, firms trying to predict competitive rivalry should anticipate that they will meet a larger number of increasingly diverse competitors in the future; thus, competitive rivalry will affect their strategies more than in the past. Teaching Note: Figure 5.2 provides a model of competitive dynamics and rivalry, but it also serves as an outline for this chapter’s discussion. You might briefly summarize the model at this point and comment that students can refer to it throughout your discussion. A MODEL OF COMPETITIVE RIVALRY Competitive rivalry exists when firms jockey with one another to pursue an advantageous market position. When one or more firms competing in an industry feels pressure to act or perceives an opportunity to improve their competitive position, competitive rivalry occurs as various firms initiate a series of actions and responses. Research findings showing that intensified rivalry within an industry results in decreased average profitability for firms competing in it and supports the importance of understanding these effects. FIGURE 5.2 A Model of Competitive Rivalry Viewing the model leads to a number of observations: • Interfirm rivalry or competitive dynamics begins with competitive analysis in terms of market commonality and resource similarity. • Market commonality and resource similarity affect the drivers of competitive behavior—a firm’s awareness, motivation, and ability to attack or respond. • Attack and responses to attack result in competitive outcomes—market position and financial performance. • Feedback from competitive outcomes will affect future competitive dynamics. Teaching Note: Competitive rivalry exists because of competitive asymmetry, which describes the fact that firms differ from one another in terms of their resources, capabilities, core competencies, and the opportunities and threats in their competitive environments and industries. It is important that firms see that competition results in mutual interdependence among firms in the industry as each firm tries to establish a sustainable competitive advantage. • As firms strive to achieve strategic competitiveness and above-average returns, they must recognize that strategies are not deployed in isolation from rival’s actions and responses. • The strategic management process represents firms taking a series of actions, fending off counter-actions or responses and developing responses of their own. 2 Describe market commonality and resource similarity the building blocks of a competitor analysis. COMPETITOR ANALYSIS A competitor analysis is the first step in predicting the extent and nature of rivalry with each competitor. Appropriate features of this kind of analysis are described below. Market Commonality Market commonality is the extent to which firms compete in the same markets. And market commonality is increasing as more and more firms compete internationally. Teaching Note: If firms overlap in a number of markets—sometimes referred to as multipoint competition—this results in a situation where firms compete against each other simultaneously in multiple geographic or product markets. This can have a significant impact on competitive dynamics (e.g., expanding into a new market that the competitor has entered to ensure that the rival does not tap a market opportunity that could then be used to support competition in core markets). In a number of industries (e.g., airlines, chemicals, pharmaceuticals, and consumer foods) the largest domestic firms compete in many of the same markets. Thus there is high market commonality. This means that each has awareness and motivation to respond to competitive interaction. Interestingly, high levels of commonality reduce the likelihood of competitive interaction. For firms that are in many common markets, there generally is competitive peace. However, when one of these firms makes a competitive move, the others are compelled to respond rapidly and aggressively. Resource Similarity Resource similarity is the extent to which a firm’s tangible and intangible resources are comparable to a competitor’s in terms of both type and amount. Firms with similar types and amounts of resources are likely to have similar strengths and weaknesses and to use similar strategies. Teaching Note: In contrast to market commonality, assessing resource similarity can be difficult, particularly when critical resources are intangible (e.g., brand name, knowledge, trust, capacity to innovate) rather than tangible (e.g., access to raw materials, ability to borrow capital). In most cases, dissimilar resources may increase the likelihood of an attack whereas firms with similar resources (overlap between their resource portfolios) will be less likely to attack because resource similarity increases the likelihood of retaliation. Teaching Note: Coca-Cola and Pepsi’s decision to target the fast-growing market for bottled water provides an example of how resource dissimilarity may cause potential competitors to be overlooked, especially by an industry’s dominant firms. This means that competitive responses of firms such as Perrier Group to protect its key bottled water brands may be delayed due to resource dissimilarity. STRATEGIC FOCUS FedEx and United Parcel Service (UPS): Maintaining Success While Competing Aggressively The Strategic Focus makes it clear that FedEx and UPS have a number of similarities – resources, markets, and the competitive dimensions they emphasize to implement their strategies. However, as resources are not identical, both companies have sought to differentiate themselves to some degree. FedEx concentrates more on transportation services and international makets. UPS concentrates more on the entire value chain while competing domestically. Both firms are continually trying to outcompete each other. Actions FedEx has taken recently include securing its contract with the US Postal Services to fly domestic mail and restructuring some of its operations to increase efficiency and findings ways for its independent express, ground, and freight networks to work together more synergistically. UPS is buying a Hungary-based pharmaceutical-logistics company to strengthen its health- care business in Europe (and giving it improved access to Central and Eastern Europe), and emphasizing trans-border European Union services to fuel its growth. An important point that is made at the end of the Strategic Focus is that while competition between these two companies is intense, it has made both firms better. Teaching Note: Most students will be aware of the high degree of competitive rivalry that exists between FedEx and UPS. Ask students to discuss how growth objectives can be achieved with this high degree of market commonality and resource similarity. FIGURE 5.3 A Framework of Competitor Analysis The results of the firm’s competitor analyses can be mapped for visual comparisons. Figure 5.3 shows different hypothetical intersections between the firm and individual competitors in terms of market commonality and resource similarity. These intersections indicate the extent to which the firm and those to which it has compared itself are competitors. For example, the firm and its competitor displayed in quadrant I of Figure 5.3 have similar types and amounts of resources and use them to compete against each other in many markets that are important to each. These conditions lead to the conclusion that the firms modeled in quadrant I are direct and mutually acknowledged competitors. In contrast, the firm and its competitor shown in quadrant III share few markets and have little similarity in their resources, indicating that they aren’t direct and mutually acknowledged competitors. The firm’s mapping of its competitive relationship with rivals is fluid as firms enter and exit markets and as companies’ resources change in type and amount. Thus, those with whom the firm is a direct competitor change across time. 3 Explain awareness, motivation, and ability as drivers of competitive behavior. DRIVERS OF COMPETITIVE ACTIONS AND RESPONSES Awareness refers to whether or not the attacking or responding firm is aware of the competitive market characteristics such as the market commonality and the resource similarity of a potential attacker or respondent. When managers are not aware of these factors or assess them inaccurately, industry overcapacity or excessive competition may result. For example, this may be a partial explanation for the recent decline in Levi Strauss’ core market as the firm appeared to be unaware of changes in teenagers’ interests as competition for their business intensified. Market commonality affects the firm’s perceptions and resulting motivation. For example, all else being equal, the firm is more likely to attack the rival with whom it has low market commonality than the one with whom it competes in multiple markets. The primary reason is that there are high stakes involved in trying to gain a more advantageous position over a rival with whom the firm shares many markets. Motivation is represented by the incentives that a firm has to either initiate an attack or to respond when attacked. Ability relates to each firm’s resources and the flexibility they provide. Without available resources (such as financial capital and people), the firm lacks the ability to attack a competitor or respond to its actions. However, similar resources suggest similar abilities to attack and respond. Resource dissimilarity also influences competitive actions and responses between firms, in that the greater the resource imbalance between the acting firm and competitors or potential responders, the greater will be the delay in response by the firm with a resource disadvantage. COMPETITIVE RIVALRY Competitive rivalry is the ongoing set of competitive actions and responses occurring between competing firms for an advantageous market position. Because the ongoing competitive action/response sequence between a firm and a competitor affects the performance of both firms, it is important for companies to carefully study competitive rivalry to successfully use their strategies. Strategic and Tactical Actions Firms use both strategic and tactical actions when forming their competitive actions and competitive responses in the course of engaging in competitive rivalry. • A competitive action is a strategic or tactical action the firm takes to build or defend its competitive advantages or improve its market position. • A competitive response is a strategic or tactical action the firm takes to counter the effects of a competitor’s competitive action. • A strategic action or a strategic response is a market-based move that involves a significant commitment of organizational resources and is difficult to implement and reverse. • A tactical action or a tactical response is a market-based move that is taken to fine-tune a strategy; it involves fewer resources and is relatively easy to implement and reverse. • Hyundai Motor Co.’s expenditures on research and development and plant expansion to support the firm’s desire to be one of the world’s largest carmakers by 2010 are strategic actions. • Tactical actions are easily reversed—pricing decisions are often taken by these firms to increase demand in certain markets during certain periods. 4 Discuss factors affecting the likelihood a competitor will take competitive actions. LIKELIHOOD OF ATTACK In addition to market commonality, resource similarity, and the drivers of awareness, motivation, and ability, other factors affect the likelihood a competitor will use strategic actions and tactical actions to attack its competitors. Three of these factors—first-mover incentives, organizational size, and quality—are described below. First-Mover Benefits First movers are the firms that take an initial competitive action, either strategic or tactical. First movers are firms that have the resources, capabilities, and core competencies that enable them to gain a competitive advantage through innovative and entrepreneurial competitive actions. By being early, the first mover hopes to: • Earn above-average returns until competitors respond effectively • Gain customer loyalty, thus creating a barrier to entry by competitors • Gain market share that can be difficult for competitors to take in the future Teaching Note: Consider the success of Harley-Davidson in large motorcycles (cruisers). In the 1980s Harley-Davidson set the standard for low, heavyweight motorcycles and has successfully defended its position by emphasizing its reputation and brand name. The firm trying to predict its rivals’ competitive actions might conclude that they will take aggressive strategic actions to gain first movers’ benefits. However, though a firm’s competitors might be motivated to be first movers, they may lack the ability to do so. First movers tend to be aggressive and willing to experiment with innovation and take higher, yet reasonable, levels of risk. To be a first mover, the firm must have readily available the resources to significantly invest in R&D as well as to rapidly and successfully produce and market a stream of innovative products. Organizational slack is what makes it possible for firms to have the ability (as measured by available resources) to be first movers. Slack is the buffer or cushion provided by actual or obtainable resources that aren’t currently in use. Thus, slack is liquid resources that the firm can quickly allocate to support the actions (e.g., R&D investments and aggressive marketing campaigns) that lead to first mover benefits. There also are dangers or disadvantages to being a first mover. • It is difficult to accurately estimate the returns that will be earned from introducing product innovations. • The first mover’s cost to develop a product innovation can be substantial, reducing the slack available to support further innovation. • Lack of product acceptance over the course of the competitor’s innovations may indicate less willingness in the future to accept the risks of being a first mover. Second movers are firms that respond to a first mover’s competitive action, typically through imitation. Doing so allows the second mover to • Avoid both the mistakes and the huge spending of the pioneers (first movers) • Have time to develop processes and technologies that are more efficient than those used by the first mover • Respond quickly to first movers’ successful, innovation-based market entries • Rapidly and meaningfully interpret market feedback to respond quickly yet successfully to the first mover’s successful innovations Teaching Note: An example of industry dynamics—and how a second mover can succeed—is provided by looking at the competitive dynamics of the athletic shoe industry. • New Balance is a second mover in the athletic shoe industry. • It effectively competes against industry leaders Nike and Reebok by focusing on the needs of a well-defined market segment. • New Balance products are not particularly innovative compared to industry leader, Nike. • New Balance is able to succeed by doing a better job of satisfying the needs of baby boomers, whose ages are significantly higher than those of Nike’s and Reebok’s core customer groups, 42, compared to 25 and 33, respectively. • New Balance offers a new model every 17 weeks, compared to six weeks for most rivals. • New Balance’s success seems to come not from rapid introductions of innovative new products, but by offering high-quality products at moderate prices and by making them available in multiple widths (ranging from AA to EEEE), recognizing that many people do not have “average” feet. Late movers are firms that respond to a competitive action, but only after considerable time has elapsed after the first mover’s action and the second mover’s response. Typically, a late response is better than no response at all, although any success achieved from the late competitive response tends to be slow in coming and considerably less than that achieved by first and second movers. As late movers are the last to respond to the first and second movers’ actions, late movers tend to be poor performers and often are weak competitors. For example, Avon was a late mover in e-commerce and Dell was a late mover in providing Internet access. Organizational Size An organization’s size affects the likelihood that it will take competitive actions as well as the types of actions it will take and their timing. Small firms are more likely to, and quicker to, launch competitive actions. Large firms are likely to initiate more competitive actions as well as strategic actions during a given time period. Thus, the competitive actions a firm will likely encounter from larger competitors will be different than the competitive actions it will encounter from smaller competitors. Large organizations often have slack resources to launch a larger number of total competitive actions, and thus do. However, smaller firms have the flexibility needed to launch a greater variety of competitive actions. Walmart appears to be an example of a large firm that has the flexibility required to take many types of competitive actions. Analysts believe that Walmart’s tactical actions are critical to its success and show a great deal of flexibility (such as a quick advertising change for 2007 back-to-school sales after disappointing spring 2007 sales). In other words, Walmart’s competitive actions will be a combination of the tendencies shown by small and large companies. Quality Product quality shapes the competitive dynamics in many industries. In fact, product quality is no longer a competitive issue but a necessary or mandatory product attribute if firms expect to successfully implement any of the generic business strategies discussed in Chapter 3—low cost, differentiation, focus, or integrated cost leadership/differentiation. Quality involves meeting or exceeding customer expectations in the products and/or services offered. Although quality is necessary, it is not a sufficient product attribute for firms to achieve strategic competitiveness. An acceptable level of quality merely provides firms with the opportunity to compete. Products and services must continue to meet customer preferences. Quality is as important in the services sector as it is in manufacturing. For the importance of quality to permeate the entire organization (and affect all of its processes and value-creating activities), a dedication to quality must come from the organization’s top-level executives. Quality affects competitive rivalry. • The firm studying a competitor with poor quality products can predict that the competitor’s costs are high and that its sales revenue will likely decline until the quality issues are resolved. • The firm can predict that the competitor is unlikely to be aggressive in terms of taking competitive actions, given that its quality problems must be corrected in order to gain credibility with customers. • Once corrected, the competitor will likely act by emphasizing additional dimensions of competition. Table Note: Quality-related dimensions of goods and services are shown in Table 5.1. TABLE 5.1 Quality Dimensions of Goods and Services Indicated in Table 5.1, the quality dimensions of products and services differ slightly from each other. As presented, the quality dimensions of products are more objective or measurable, relating to performance, features, flexibility, durability, conformance, serviceability, aesthetics, and perceived quality. In contrast, the quality dimensions of services are more subjective, dealing with timeliness, courtesy, consistency, convenience, completeness, and accuracy 5 Describe factors affecting the likelihood a competitor will respond to actions taken by its competitors. LIKELIHOOD OF RESPONSE Once a competitive action has been taken, its success generally is determined by the likelihood and nature of the competitive response. In general, a firm is likely to respond to a competitor’s action when 1. The action leads to better use of the competitor’s capabilities to gain or produce stronger competitive advantages or an improvement in its market position, 2. The action damages the firm’s ability to use its capabilities to create or maintain an advantage, or 3. The firm’s market position becomes less defensible. To predict how a competitor is likely to respond to competitive actions, firms should consider (see Figure 5.2): • Market commonality and resource similarity • Awareness, motivation, and ability • Type of competitive action, reputation, and market dependence Type of Competitive Action Teaching Note: Remember, competitive actions are significant competitive moves taken by a firm that are designed to gain a competitive advantage in a market, with the type of competitive action taken being based on the firm’s strategy (described in Chapter 4). Competitive actions can be classified based on the scope or breadth and significance of the action. The likelihood of a competitive response to an action depends on the type of action taken— strategic or tactical—and the potential effect on competitors. Because strategic actions require the use or dedication of specific organizational resources, are more difficult to implement successfully, are more time consuming, and are difficult (and often costly) to reverse, it is more likely that tactical actions will be implemented and responded to more often. Because tactical actions require fewer organizational resources and are relatively easy to implement and reverse, their effects on the competitive situation are more immediately felt. Some examples of strategic actions include: • Walmart’s entry into the European market • Continental’s decision to initiate flights into Lima, Peru • Bank One’s implementation of an Internet banking company Teaching Note: Tactical actions are taken to fine-tune a strategy. They involve fewer and more general organizational resources and are relatively easy to implement and reverse, if necessary. Fare increases (decreases) in the airline industry represent tactical actions. They require few organizational resources (other than communicating new prices), are relatively easy to implement, and can be reversed. Tactical actions also are generally more quickly responded to by competitors than are strategic actions. Teaching Note: It can be instructive to compare the rapid response by airlines to competitors’ tactical actions (such as fare reductions) to American Airline’s acquisition of another airline company and its $1 billion purchase of gates at JFK airport to respond to Continental’s efforts to gain market share (strategic actions). Actor’s Reputation To predict the likelihood of a competitor’s response to a current or planned action, the firm studies the responses that that competitor has taken previously when attacked, in that past behavior is assumed to be a reasonable predictor of future behavior. Competitors are more likely to respond to either strategic or tactical actions taken by a market leader. For example, competitive actions taken by Home Depot are almost certain to incite a response from Lowe’s. Teaching Note: Some likely effects of reputation are the following: • Actions initiated by firms with a previous history of success also will be more likely to result in quick reactions and imitation. • Actions taken by firms with reputations for risk-taking and for initiating complex and unpredictable actions are less likely to be responded to. • Actions taken by price predators (firms who cut prices to capture market share and then raise prices) are seen as having a negative effect on competitors and their actions receive only minimal response and imitation. Market Dependence Market dependence denotes the extent to which a firm’s revenues/profits are derived from a particular market. Firms that are highly concentrated in—or dependent on—an industry (or market) in which a competitive action has been taken are more likely to respond than are firms who do business in multiple industries and markets. 6 Explain competitive dynamics in slow-cycle, in fast-cycle, and in standard-cycle markets. COMPETITIVE DYNAMICS Teaching Note: Recall that Figure 5.1 illustrates the potential outcomes of interfirm rivalry. Whereas competitive rivalry concerns the ongoing actions and responses between a firm and its competitors for an advantageous market position, competitive dynamics concerns the ongoing actions and responses taking place among all firms competing within a market for advantageous positions. To explain competitive dynamics, it is important to understand the effects of varying rates of competitive speed in different markets (called slow-cycle, fast-cycle, and standard-cycle markets) on the behavior (actions and responses) of all competitors within a given market. Competitive behaviors as well as the reasons or logic for taking them are similar within each market type, but differ across market type. Thus, competitive dynamics differ in slow-cycle, fast-cycle, and standard-cycle markets. The sustainability of the firm’s competitive advantages differs across the three market types. Slow-Cycle Markets Slow-cycle markets are those in which the firm’s competitive advantages are shielded from imitation, often for long periods of time, and where imitation is costly. Thus, competitive advantages are sustainable in slow-cycle markets. Building a unique competitive advantage that is proprietary leads to competitive success in a slow-cycle market. This type of advantage is difficult for competitors to understand. Copyrights, geography, patents, and ownership of an information resource are examples of what leads to unique advantages. Teaching Note: Noted in Chapter 3, a difficult-to-understand and costly-to- imitate advantage can be the result of unique historical conditions, causal ambiguity, and/or social complexity. Once a proprietary advantage is developed, the firm’s competitive behavior in a slow-cycle market is oriented toward protecting, maintaining, and extending that advantage. Teaching Note: Providing some examples may help students understand what has been involved in establishing and defending a one-of-a-kind competitive advantage. The following are some possibilities: • IBM’s historical dominance of the mainframe computer industry • Boeing’s dominant position in larger, commercial jet aircraft (at least until the Airbus super-jumbo jet hits the market) • Microsoft’s dominant position in the market for PC operating system software (though diminished somewhat by a recent swell of new competitors) • Walmart’s use of local market monopolies as it established its dominant position in discount retailing by setting up stores in small, rural communities Figure Note: The sustainability of competitive actions in slow-cycle markets is illustrated in Figure 5.4. FIGURE 5.4 Gradual Erosion of a Sustained Competitive Advantage As indicated by Figure 5.4, a firm operating in a slow-cycle market may be able to retain its competitive advantage over time. • Returns from the competitive action increase during the early, launch years of the strategy. • When returns level out, the firm exploits its position. • Competitors counterattack or launch strategies that cause the first firm’s bases for competitive advantage to erode. As a result, returns are competed away. Fast-Cycle Markets Fast-cycle markets are those in which the firm’s competitive advantages aren’t shielded from imitation and where imitation happens quickly and somewhat inexpensively through reverse engineering and technology diffusion. Competitive advantages aren’t sustainable in fast- cycle markets. The technology often used by fast-cycle competitors isn’t proprietary, nor is it protected by patents as is the technology used by firms competing in slow-cycle markets. For example, only a few hundred parts readily available on the open market are required to build a PC. Patents protect only a few of these parts, such as microprocessor chips. Fast-cycle markets are more volatile than slow-cycle and standard-cycle markets. Prices fall quickly in these markets, so companies need to profit quickly from their product innovations (e.g., rapid declines in the prices of microprocessor chips produced by Intel and Advanced Micro Devices continuously reduces their prices to end users). Imitation of many fast-cycle products is relatively easy, as demonstrated by Dell and Gateway, along with a host of local PC vendors. All of these firms have partly or largely imitated IBM’s initial PC design to create their products. Teaching Note: The focus of fast-cycle competition is competitive disruption, an approach where competition is based on one set of resources and then shifted to another—in other words, using price as a first step toward sustaining a competitive advantage, then shifting to quality, then speed, then innovation, and so on. The principle is that the primary basis of the competitive advantage is shifted as the firm disrupts and changes the rules of the game. Firms in fast-cycle markets avoid “loyalty” to any of their products, preferring to cannibalize their own before competitors learn how to do so through successful imitation. This emphasis creates competitive dynamics that differ substantially from slow-cycle markets. Instead of concentrating on protecting, maintaining, and extending competitive advantages, these companies focus on learning how to rapidly and continuously develop superior advantages. Figure Note: Figure 5.5 can be used to discuss how competitive advantage would unfold in a fast-cycle market. FIGURE 5.5 Developing Temporary Advantages to Create Sustained Advantage As illustrated, one way in which firms might sustain a competitive advantage is to move continuously from advantage to advantage. This is accomplished by moving from one source of advantage to another, never allowing competitors to catch up. Examples of firms that have successfully followed the incremental approach to sustain competitive advantage are Vodaphone in telecommunications services and Cisco Systems in telecommunications systems. Teaching Note: The following has been prescribed as the incremental or step-by-step approach to managing competitive advantages in fast-cycle markets. 1. Disrupt the status quo A firm should identify new opportunities to meet customer needs, thereby shifting or changing the basis of competition. 2. Create a temporary advantage The temporary advantage should be based on improved knowledge of customers’ needs, innovative application of technology, and an attempt to define the future basis of customer satisfaction. 3. Seize the initiative Move aggressively and rapidly, forcing competitors to play catch up; take a proactive approach while leaving competitors to be reactive. 4. Sustain the momentum Continue to develop new sources of advantage; don’t wait for competitors to catch up; stay one step ahead. Teaching Note: As discussed earlier, the contemporary competitive landscape requires that firms (1) introduce more new products, (2) develop broader product lines, and (3) provide more rapid product upgrades. Standard-Cycle Markets Standard-cycle markets are those in which the firm’s competitive advantages are moderately shielded from imitation and where imitation is moderately costly. Competitive advantages are partially sustainable in standard-cycle markets, but only when the firm is able to continuously upgrade the quality of its competitive advantages. The competitive actions and responses that form a standard-cycle market’s competitive dynamics find firms seeking large market shares, trying to gain customer loyalty through brand names, and carefully controlling their operations to consistently provide the same usage experience for customers without surprises. Because of large volumes, the size of mass markets, and the need to develop scale economies, the competition for market share is intense in standard-cycle markets. P&G and Unilever are direct competitors—they share multiple markets, have similar types and amounts of resources, and follow similar strategies. For example, they both compete aggressively for market share in laundry detergents, where tiny fractions make a huge difference at the bottom line. Innovation has a substantial influence on competitive dynamics as it affects the actions and responses of all companies competing within a slow-cycle, fast-cycle, or standard-cycle market. Chapter 6 Corporate-Level Strategy LEARNING OBJECTIVES 1. Define corporate-level strategy and discuss its purpose. 2. Describe different levels of diversification achieved using different corporate-level strategies. 3. Explain three primary reasons firms diversify. 4. Describe how firms can create value by using a related diversification strategy. 5. Explain the two ways value can be created with an unrelated diversification strategy. 6. Discuss the incentives and resources that encourage diversification. 7. Describe motives that can encourage managers to overdiversify a firm. CHAPTER OUTLINE Opening Case General Electric: The Classic Diversified Firm LEVELS OF DIVERSIFICATION Low Levels of Diversification Strategic Focus Sany’s Highly Related Core Businesses Moderate and High Levels of Diversification Reasons for Diversification VALUE-CREATING DIVERSIFICATION: RELATED CONSTRAINED AND RELATED LINKED DIVERSIFICATION Operational Relatedness: Sharing Activities Corporate Relatedness: Transferring of Core Competencies Market Power UNRELATED DIVERSIFICATION Efficient Internal Capital Market Allocation Restructuring of Assets Strategic Focus Ericsson’s Substantial Market Power VALUE-NEUTRAL DIVERSIFICATION: INCENTIVES AND RESOURCES Incentives to Diversify Resources and Diversification VALUE-REDUCING DIVERSIFICATION: MANAGERIAL MOTIVES TO DIVERSIFY SUMMARY REVIEW QUESTIONS EXPERIENTIAL EXERCISES VIDEO CASE LECTURE NOTES Chapter Introduction: Chapters 4 and 5 looked at strategy at the level of the business and focused on the factors and approaches that can lead to competitive advantage and superior performance. Chapter 6 takes this a step further by standing back to consider strategy at a higher level—corporate strategy. The concern here is for the performance benefits that are derived from putting together an effective “portfolio of businesses”—that is, putting businesses together in a way that makes sense and can generate synergies between units. The discussion of this chapter builds toward a summary presented in Figure 6.4. It might be helpful to review that figure carefully before starting into the material of the chapter. OPENING CASE General Electric: The Quintessential Diversified Firm General Electric is a diversified company with a storied past. While GE’s businesses compete in a number of different industries, because of similarities among some of them, they are currently grouped into four divisions: GE Capital, GE Energy, GE Technolgy Infrastructure, and GE Home and Business Solutions. In recent years, however, more than 50 percent of GE’s annual revenue came from the GE Capital division. Though it has enjoyed success throughout its history, recent performance has been unimpressive. NBC never achieved expected success (and was recently sold) and the performance of its financial services business has been weak since 2008 (although in 2012 it produced revenue and profit growth). Stock price has been down for over a decade. GE appears to be placing large acquisition bets on its green energy business and making substantial investments to be a force in the new industrial Internet industry. It is also beginning to see strong growth from some of its international investments Teaching Note: GE has encountered numerous problems during its history but it appears that it is beginning to regain its footing. Over the past decade GE management capability has been called into question and its stock performance has been weak. GE’s stock has gone from around $60 per share in 2000 to around $23 in mid-2013. Its exposure to European debt is tremendous and if the euro collapses, GE would be severely crippled, if it survived at all. For reasons that are not at all obvious, CEO Immelt remains at the helm despite GE’s awful performance record over the past decade. Ask students to evaluate GE’s mix of businesses. Does this combination make sense? Ask students how GE’s board should evaluate management performance and what might be done to address some of GE’s problems. 1 Define corporate-level strategy and discuss its purpose. Remember that in Chapters 4 and 5 the discussion centered around selecting and implementing a business-level or competitive strategy—actions a firm should take to compete in a single industry or product market—and the actions and responses that affect the competitive dynamics of a single industry or product market. In contrast, when a firm diversifies its operations by operating business in several industries, corporate-level strategy becomes a primary focus. This means that a diversified firm has two levels of strategy: business-level (or competitive) and corporate-level (or company-wide), the latter of which entails selecting a strategy that focuses on the selection and management of a mix of businesses. Corporate-level strategies detail actions taken to gain a competitive advantage through the selection and management of a mix of businesses competing in several industries or product markets. Primary concerns of corporate-level strategy are: • What businesses should the firm be in? • How should the corporate office manage its group of businesses? • How can the corporation as a whole add up to more than the sum of its business parts? The ultimate measure of the value of a firm’s corporate-level strategy is that the businesses in the firm’s portfolio are worth more under current management (and by following the firm’s corporate-level strategy) than they would be under different ownership or management. Teaching Note: Indicate to students that the unique organizational structure that is required by this strategy is discussed in Chapter 11. LEVELS OF DIVERSIFICATION Diversified firms vary according to two factors: • The level of diversification • Connection or linkages between and among business units Figure Note: Five levels of diversification are listed and each is defined in Figure 6.1. It is recommended that you refer students to Figure 6.1 as you begin to discuss levels of diversification in more detail. FIGURE 6.1 Levels and Types of Diversification Figure 6.1 should be used as a reference point during your discussion of diversification types. Students’ attention should be directed to inter-unit linkages depicted on the right side of Figure 6.1. Levels and types of diversification defined in Figure 6.1 and discussed in more detail in the next sections of this chapter are: Low levels of diversification • Single business • Dominant business Moderate to high levels of diversification • Related-constrained diversification • Related-linked diversification (mixed related and unrelated) Very high levels of diversification • Unrelated diversification 2 Describe different levels of diversification achieved using different corporate-level strategies. Low Levels of Diversification Firms that follow single- or dominant-business strategies have low levels of diversification. A single business is a firm where more than 95 percent of its revenues are generated by the dominant business. Firms such as the Wrigley Co. are examples of single-business firms. Wrigley Co. has dominated the global gum-related industry as the largest manufacturer of chewing gum, specialty gums, and gum bases. Its brands, Doublemint, Spearmint, and Juicy Fruit, led the market. Teaching Note: Wrigley has chosen to focus its attention on its historic (since 1915) core business. It competes effectively (and successfully) against large diversified firms, including RJR Nabisco (Beechnut and Carefree) and Warner-Lambert (Trident and Dentyne). Focusing on its core business has enabled Wrigley’s top-level managers to maintain strategic control of the business. As a result, Wrigley maintains a clear, strategic focus and is highly competitive in its core business (though it is beginning to diversify somewhat in recent years). A dominant business is a firm that generates between 70 and 95 percent of its sales within a single business area. Teaching Note: UPS is an example of a dominant business firm because, although 22 percent of revenue comes from international operations, it generates 60 percent of its revenue from its US package delivery service. STRATEGIC FOCUS Sany’s Highly Related Core Businesses Sany Heavy Industry Company, Ltd. Is China’s largest producer of heavy equipment (and 5th largest globally). Sany’s businesses consist of cranes, road construction machinery, port machinery, and pumpover machinery. Some technologies used in the production and in its products is similar which makes transferring knowledge across these businesses easier to accomplish. Additional similarities exist in customers and markets served. Sany invests 5 percent of sales in R&D and through the end of 2012 held 3,303 patents. It has developed new post-doctoral research centers to attract top research scientists. Sany is positioning itself to improve its global position through acquisitions, the establishment of subsidiaries in many countries, and the relocation of its headquarters. Teaching Note: Sany has been able to grow its business through a solid mix of related businesses. These businesses can help each other improve offerings, reduce costs, and expand the company’s global reach. It should be noted that the company has strengthen its position both through acquisitions and company- initiated growth. Ask students to identify other diversified firms (domestic and/or global) in which the mix of businesses improves the organization’s overall performance (market and financial). Moderate and High Levels of Diversification A related-diversified firm is one that earns at least 30 percent of its revenues from sources outside the dominant business and whose units are related to each other—e.g., by the sharing of resources and by product, technological, and distribution linkages. Related-constrained firms also earn at least 30 percent of their revenues from the dominant business, and all business units share product, technological, and distribution linkages, as illustrated in Figure 6.1. Kodak, Procter & Gamble, and Campbell’s Soup Company are related-constrained firms. Related linked (mixed related and unrelated) firms, such as Campbell Soup and P&G, generate at least 30 percent of their total revenues from the dominant business, but there are few linkages between key value-creating activities. Unrelated-diversified (or highly diversified) firms do not share resources or linkages, as illustrated in Figure 6.1. Firms that pursue unrelated diversification strategies—often known as conglomerates—include United Technologies, Samsung, and Textron. Though there are more unrelated diversified firms in the US than in most other countries, conglomerates (firms following unrelated diversification strategies) dominate the private sector economy in Latin America and in several emerging economies (such as China, South Korea, and India). Teaching Note: Many firms that have at one time pursued unrelated diversification strategies are restructuring to focus on a less diversified mix of businesses, a move that may reflect: • An inability to manage high levels of diversification • Recognition that a lower level of diversification would improve the match between the firm’s core competencies and environmental opportunities and threats 3 Explain three primary reasons firms diversify. REASONS FOR DIVERSIFICATION Teaching Note: The content of this section of the chapter generally is limited to a discussion of Table 6.1, which provides some of the reasons that firms implement diversification strategies. The various value-related motives for diversification are discussed in more detail in the remainder of the chapter as specific diversification strategies are discussed. Firms may implement diversification strategies to enhance or increase the strategic competitiveness of the overall organization, and thus the value of the firm increases. Value can be created through either related or unrelated diversification if the strategies enable the firm’s mix of businesses to increase revenues and/or decrease costs when implementing business-level strategies. Firms may implement diversification strategies that are either value neutral or result in devaluation of the firm. They may attempt to diversify: • To neutralize a competitor’s market power • To reduce managers’ employment risk (i.e., risk of the CEO being unemployed when a dominant-business firm fails as compared to this risk when a single business fails when it is only one part of a diversified firm) • To increase managerial compensation because of the positive relationships between diversification, firm size, and compensation Table Note: Reasons or motives for implementing diversification strategies are presented in Table 6.1. They are discussed in the following chapter sections. TABLE 6.1 Reasons for Diversification Firms follow diversification strategies for many reasons. These can be grouped into three broad sets of motives: Motives to create value: • Economies of scope (related diversification) through activity-sharing and the transfer of core competencies • Market power motives (related diversification) by vertical integration or blocking competitors via multipoint competition • Financial economies motives (unrelated diversification) to improve efficiency of capital allocation through an internal capital market or by restructuring the portfolio of businesses Motives that are value-neutral with respect to strategic competitiveness: • To avoid violations of antitrust regulations • To take advantage of tax incentives • To overcome low performance • To reduce the uncertainty of future cash flows • To reduce overall firm risk • To exploit tangible resources • To exploit intangible resources Managerial or value-reducing motives: • To diversify managerial employment risk • To increase managerial compensation Figure Note: As illustrated in Figure 6.2, firms seek to create value by sharing activities and transferring skills or corporate core competencies. This figure can help students organize their thoughts about the options firms have to exploit various forms of relatedness. FIGURE 6.2 Value-Creating Strategies of Diversification: Operational and Corporate Relatedness Firms seek to create value from economies of scope through two basic kinds of operational economies: sharing activities and transferring skills (corporate core competencies). However, the levels of the two will lead to different corporate strategies with different advantages associated with each. Combinations of Economies Resulting Strategy Economies for Advantage High operational/ Low corporate Vertical integration Market power Low operational/ Low corporate Unrelated diversification Financial economies High operational/ High corporate Both operational and relatedness Rare capability and can create diseconomies of scope High operational/ High corporate Related-linked diversification Economies of scope VALUE-CREATING DIVERSIFICATION: RELATED CONSTRAINED AND RELATED LINKED DIVERSIFICATION Firms implement related diversification strategies in order to achieve and exploit economies of scope and build a competitive advantage by building on existing resources, capabilities, and core competencies. For firms that operate in multiple industries or product markets, economies of scope represent cost savings attributed to entering an additional business and sharing activities or using capabilities and core competencies developed in another business that can be transferred to a new business without significant additional costs. The difference between activity sharing and core competence sharing is based on how different resources are used jointly to create economies of scope: • To create economies of scope, tangible resources such as plant and equipment or other business-unit physical assets often must be shared. Less tangible resources, such as manufacturing know-how, also can be shared. • Know-how transferred between separate activities with no physical or tangible resource involved is a transfer of a corporate-level core competence, not an operational sharing of activities. A key to creating value through sharing essentially separate activities is to share know-how or skills rather than physical or tangible resources. Operational Relatedness: Sharing Activities Because all of its businesses share product and technological and distribution linkages, activity sharing is common among related-constrained diversified firms, such as Procter & Gamble. P&G’s paper towel and disposable diaper units can share many activities due to their common characteristics: • Each business uses paper products as a key input, so they are likely to share key facets of procurement and inbound logistics, as well as primary manufacturing activities. • Because all three businesses produce consumer products that are sold in similar (if not the same) outlets, they will likely share outbound logistics, distribution channels, and possibly sales forces. Firms also must recognize that although activity sharing is intended to reduce costs through achieving economies of scope, there are incremental costs related to sharing activities (costs that are created by sharing). These costs must be recognized and taken into account when planning activity sharing or scope economies may not result. Activity sharing can also result in new risks since closer linkages between business units create tighter interrelationships and/or interdependencies. For example, if two business units share production facilities and sales in one unit’s products decline to the point that revenues no longer cover the costs of shared production, then each business unit’s ability to achieve strategic competitiveness may be adversely affected. Regardless of the risks that accompany activity sharing, research indicates that activity sharing—or the potential for activity sharing—can increase the value of the firm. Some findings are summarized here: • Acquiring firms in the same industry—a horizontal acquisition—where sharing of activities and resources is implemented results in improved performance and higher returns to shareholders. • Selling off units where resource sharing is a possible source of economies of scope results in lower returns to shareholders than does selling off business units unrelated to the firm’s core business. • Firms with more related units have less risk. 4 Describe how firms can create value by using a related diversification strategy. Corporate Relatedness: Transferring of Core Competencies Over time, most firms develop intangible resources that can become a foundation for corporate-level core competencies that are competitively valuable. In diversified firms, these core competencies generally are made up of managerial and technical knowledge, experiences, and expertise. There are at least two ways the related linked diversification strategy helps firms create value: • Any costs related to developing the competence have already been incurred • Competencies based on intangible resources, such as marketing know-how, are less visible and therefore are more difficult for competitors to understand and imitate Teaching Note: As an example, Philip Morris acquired Miller Brewing at a time when competition in the brewing industry was focused on establishing efficient operations. • Philip Morris used marketing competencies coming from the competitive cigarette industry. • No brewing firm used marketing capabilities as a source of competitive advantage. • By transferring its marketing competence to Miller, Philip Morris introduced marketing as a source of competitive advantage to the brewing industry. • Because its primary competitor, Anheuser-Busch, was unable to develop the capability to respond for several years, Miller’s strategic action (mostly effective advertising campaigns) let Miller achieve a temporary competitive advantage and earn above-average returns. Other firms have focused on transferring a variety or resources/capabilities across businesses in their control. • Virgin has transferred its marketing skills across travel, cosmetics, music, drinks, and other retail businesses. • Thermo Electron has employed its entrepreneurial skills in starting up a number of new ventures and maintaining a new venture network. • Honda has developed and transferred across its businesses its expertise in small and now larger engines for a number of vehicle types—from motorcycles and lawnmowers to its range of automotive products. One way that firms can facilitate the transfer of competencies between or among business units is to move key personnel into new management positions in the receiving unit. However, research suggests that transferring expertise often does not lead to performance improvement. Teaching Note: It is good to help students understand the human dimensions of strategic decisions—e.g., expertise transfers may be difficult or costly because of the following: • A business-unit manager of an older division may be reluctant to transfer key people who have accumulated knowledge and experience critical to the business unit’s success. • Managers able to facilitate the transfer of core competencies may come at a premium. • The key people involved may not want to transfer. • The top-level managers from the transferring division may not want the competencies transferred to a new division to fulfill the firm’s diversification objectives. Market Power Firms also may implement related diversification strategies in an attempt to gain market power. • Market power exists when a firm is able to sell its products at prices above the existing competitive level or decrease the costs of its primary activities below the competitive level, or both. • Market power through diversification may be gained through multipoint competition, a condition where two or more diversified firms compete in the same product areas or geographic markets. Firms also might gain market power by following a vertical integration strategy, which exists when a company produces its own inputs (backward integration) or owns its own distribution system (forward integration). A vertical integration strategy may be motivated by a firm’s desire to strengthen its position in its core business relative to competitors by increasing its market power. Vertical integration enables a firm to increase market power by: • Developing the ability to save on its operations • Avoiding market costs • Improving product quality • Protecting its technology from imitation by rivals • Having strong ties between their assets for which no market prices exist Note: establishing a market price would result in high search and transaction costs, so firms seek to vertically integrate rather than remain separate businesses. Teaching Note: As an example of vertical integration, CVS, a Walgreen’s competitor, recently merged with Caremark, a pharmaceutical benefits manager. This represents a vertical move for CVS from a retail-only firm to broader-based health care. However, CVS risks alienating Walgreen’s, which may then choose to align with another benefits manager. However, like other strategies that create value and aid the firm in achieving strategic competitiveness, vertical integration may not be the perfect answer because of risks and costs that accompany it. • Outside suppliers may be able to provide inputs at a lower cost (and, possibly also of a higher quality). • The costs of coordinating vertically integrated activities may exceed the value of the control realized. • Vertical integration may result in the firm losing strategic competitiveness if the internal unit does not keep up with changes in technology. • To vertically integrate, the firm may need to build a facility with capacity that exceeds the ability of its internal units to absorb, forcing the selling unit to sell to outside users in order to achieve scale economies. Many manufacturing firms no longer pursue vertical integration. In fact, deintegration is the focus of most manufacturing firms, such as Intel and Dell, and even among large automobile companies, such as Ford and General Motors, as they develop independent supplier networks. Solectron Corp., a contract manufacturer, represents a new breed of large contract manufacturers that is helping to foster this revolution in supply-chain management. Such firms often manage their customers’ entire product lines, and offer services ranging from inventory management to delivery and after-sales service. E-commerce allows vertical integration to turn into “virtual integration,” permitting closer relationships with suppliers and customers through electronic means of integration. This lets firms reduce transaction costs while boosting supply-chain management skills and tightening inventory control. STRATEGIC FOCUS Ericsson’s Substantial Market Power Ericsson is the largest global manufacturer of mobile telecommunications networks equipment (with 38 percent global market share in 2012). It has a presence in 108 countries and its business unit support systems provides charging and billing service for 1.6 billion people. Ericsson has three primary businesses: business unit networks, business unit support systems, and business unit global services. As these businesses are all related to some degree it is clear that Ericsson is following a related-constrained diversification strategy. Ericsson is facing formidable competition from Huawei and Samsung. To stay ahead of competitors Ericsson makes ‘major’ investments in R&D to develop new technologies and products. It estimates that 5G wireless, federated networked cloud services, and 3d visual communications will be needed in the near future and it is positioning itself to be a leader in all of these areas. Teaching Note: Ericsson is competing in a fast-cycle industry. As such, it needs to continually be on the offense with respect to the development of new products and services to maintain its leadership position. Students will be aware of the need to create innovations in technology-related businesses. This Strategic Focus provides an opportunity for students to realize that companies (such as Ericsson) need to place their bets on where the industry is going far in advance. Ask students to identify some of the risks inherent in this approach given the highly uncertain nature of technological innovation and market development that exists for these companies. Ask them to discuss how a related-constrained strategy approach helps to deal with some of this uncertainty. Simultaneous Operational and Corporate Relatedness As Figure 6.2 suggests, some firms simultaneously seek operational and corporate relatedness to create economies of scope. Because simultaneously managing two sources of knowledge is very difficult, such efforts often fail, creating diseconomies of scope. A Bit of Disney History: A Mini-Case By using operational relatedness and corporate relatedness, Disney made $3 billion on the 150 products that were marketed with its movie, The Lion King. Sony’s Men in Black was a super hit at the box office and earned $600 million, but box office and video revenues were practically the entire success story. Disney was able to accomplish its great success by sharing activities regarding The Lion King theme within its movie, theme park, music, and retail products divisions, while at the same time transferring knowledge into these same divisions, creating a music CD, Rhythm of the Pride Lands, and producing a video, Simba’s Pride. In addition, there were Lion King themes at Disney resorts and Animal Kingdom parks. However, it is difficult for analysts from outside the firm to fully assess the value-creating potential of the firm pursuing both operational relatedness and corporate relatedness. As such, Disney’s assets as well as other media firms such as AOL Time Warner have been discounted somewhat because “the biggest lingering questions is whether multiple revenue streams will outpace multiple-platform overhead.” 5 Explain the two ways value can be created with an unrelated diversification strategy. UNRELATED DIVERSIFICATION Firms implementing unrelated diversification strategies hope to create value by realizing financial economies, which are cost savings realized through improved allocations of financial resources based on investments inside or outside the firm. Financial economies are realized through internal capital allocations (that are more efficient than market-based allocations) and by purchasing other companies and then restructuring their assets. Efficient Internal Capital Market Allocation Although capital generally is efficiently distributed in a market economy through the capital markets, large diversified firms may be able to distribute capital more efficiently to divisions and thus create value for the overall organization. This generally is possible because: • Corporate offices have more detailed and accurate information on actual division performance and future prospects. • Investors have limited access to internal information and generally can only estimate division performance. One implication of increased access to information is that the internal capital market may be able to allocate resources between investment opportunities more accurately (and at more adequate levels) than the external capital market. There are several reasons for this: • Information disclosed to capital markets through annual reports may not fully disclose negative information, reporting only positive prospects while meeting all regulatory disclosure requirements. • External capital sources have limited knowledge of what is taking place within large, complex firms. • While owners have access to information, full and complete disclosure is not guaranteed. • An internal capital market may enable the firm to safeguard information related to its sources of competitive advantage that otherwise might have to be disclosed. Through disclosure, the information could become available to competitors who might use the information to duplicate or imitate the firm’s sources of competitive advantage. Other advantages of internal capital markets: • Corrective actions may be more efficiently structured and underperforming management can be more effectively disciplined through the internal capital market than through external capital market mechanisms. Thus, the internal capital market is more capable of taking specific, finely tuned corrective actions compared to the external market. • If external intervention is required, only drastic alternatives generally are available, such as forcing the firm into bankruptcy or forcing the removal of top-level managers. • With an internal capital market, the corporate office can adjust managerial incentives or can suggest strategic changes to make the desired corrections. Research suggests that in efficient capital markets, the unrelated diversification strategy may be discounted. Stock markets have applied what some have called a “conglomerate discount” reflected in the valuation of diversified manufacturing conglomerates at 20 percent less, on average, than the value of the sum of their parts. The Achilles heel of the unrelated diversification strategy is that conglomerates in developed economies have a fairly short life cycle because financial economies are more easily duplicated than are the gains derived from operational relatedness and corporate relatedness. This is less of a problem in emerging economies, where the absence of a “soft infrastructure” (e.g., effective financial intermediaries, sound regulations, and contract laws) supports and encourages use of the unrelated diversification strategy. In fact, in emerging economies such as those in India and China, diversification increases performance of firms from large diversified business groups. Restructuring of Assets A restructuring approach to creating value in an unrelated diversified firm involves the buying and selling of other companies (and their assets) in the external market. Following the asset sale and layoffs, underperforming divisions (those acquired in the purchase) are sold to other firms and remaining divisions are placed under strict budgetary controls accompanied by the reporting of cash inflows and outflows to the corporate office. Tyco International: A Question of Ethics Under former CEO Dennis L. Kozlowski, Tyco International, Ltd. excelled at exploiting financial economies through restructuring. Tyco focused on two types of acquisitions: platform, which represented new bases for future acquisitions, and add- on, in markets where Tyco currently had a major presence. As with many unrelated diversified firms, Tyco acquired mature product lines. However, completing large numbers of complex transactions resulted in accounting practices that aren’t as transparent as stakeholders now demand. In fact, many of Tyco’s top executives, including Kozlowski, were arrested for fraud, and the new CEO, Edward Breen, has been restructuring the firm’s businesses to overcome “the flagrant accounting, ethical, and governance abuses of his predecessor.” Actions being taken in firms such as Tyco suggest that firms creating value through financial economies are responding to the demand for greater transparency in their practices. Responding in this manner will provide the information the market needs to more accurately estimate the value the diversified firm is creating when using the unrelated diversification strategy. Success in implementing unrelated diversification strategies usually requires that firms: • Focus on firms in mature, low technology industries • Avoid service businesses because of their client- or sales-orientation 6 Discuss the incentives and resources that encourage diversification. VALUE-NEUTRAL DIVERSIFICATION: INCENTIVES AND RESOURCES As mentioned earlier, not all firms diversify to increase the value of the overall firm. Some attempts at diversification are implemented to prevent the value of the firm from decreasing. Incentives to Diversify In most instances managers have a choice regarding the level of diversification that their firm should implement. In addition, both the external and internal environments are sources of incentives or reasons that managers might use to justify diversification choices. Antitrust Regulation and Tax Laws In the 1960s and 1970s, government policies—in the form of antitrust enforcement and tax laws—provided US firms with incentives to diversify the mix of businesses controlled by the firm. As a result of these policies, the vast majority of mergers during the period represented unrelated diversification. They were classified as conglomerate mergers. Conglomerate mergers (unrelated diversification) were encouraged in large part by the Celler-Kefauver Act, which discouraged horizontal and vertical mergers. That is, federal legislation (and enforcement by the US Department of Justice) discouraged market power boosting via related diversification. As one measure of the effectiveness of official “discouragement,” almost 80 percent of mergers during the 1973–1977 period were conglomerate mergers. During the 1980s, enforcement of antitrust laws slackened and firms chose to implement horizontal merger strategies (or mergers with firms in the same [or a related] line of business). At the same time, investment bankers aggressively promoted merger and acquisition activity to the extent that many acquisitions were classified as unfriendly or hostile takeovers. Firms that had diversified (in an unrelated fashion) in the 1960s and 1970s began to implement strategies to refocus their firms, and an era of restructuring began. When firms generate more cash than they are able to profitably reinvest in the firm’s primary activities, the excess funds, or “free cash flows,” should be returned to shareholders in the form of dividends. However, during the 1960s and 1970s, dividends were taxed more heavily than ordinary personal income. (Dividends are taxed twice: once when the firm pays taxes on its operating income and a second time when net income is paid out to shareholders in the form of dividends as shareholders pay a tax on dividends received at their personal income tax rate.) In 1986, the perspective shifted once again, as the Tax Reform Act of 1986 reduced the top personal income tax rate from 50 percent to 28 percent. Capital gains rules were changed so that capital gains would be taxed at the ordinary personal income tax rate, and personal interest deductibility was eliminated. These changes in federal tax laws that affected individual tax rates for dividends and capital gains (with the former decreasing and the latter increasing), have created an incentive for shareholders to favor reduced levels of diversification (after 1986) unless funded by tax- deductible debt. The recent changes recommended by the Financial Accounting Standards Board (FASB), regarding the elimination of the “pooling of interests” method for accounting for the acquired firm’s assets and the elimination of the write-off for research and development in process, reduce some of the incentives to make acquisitions, especially related acquisitions in high- technology industries. Although there was a loosening of federal regulations in the 1980s and a retightening in the late 1990s, a number of industries have experienced increased merger activity due to industry-specific deregulation activity, including banking, telecommunications, oil and gas, and electric utilities. Low Performance When firms are able to earn above-average or superior returns in a single business, they have little incentive to diversify (as previously discussed in the Wrigley Co. example). However, low performance may provide an incentive for diversification as a low-performing firm may become more risk-seeking in an effort to improve overall firm performance. In response to low returns (or poor performance), firms often choose to seek greater levels of diversification. At some point, however, poor performance slows the pace of diversification, often resulting in restructuring divestitures of businesses to lower the level of firm diversification. Figure Note: The relationship between level of performance and diversification (for firms that already have diversified) is illustrated in Figure 6.3. FIGURE 6.3 The Curvilinear Relationship Between Diversification and Performance As Figure 6.3 illustrates, firms exhibiting low performance in their dominant businesses often implement related-constrained diversification strategies that, to a certain point, result in increased performance. In search of even higher performance, related-diversified firms may continue to diversify, but elect to acquire unrelated businesses. When a firm’s core competencies do not create value in unrelated businesses, firm performance decreases. Teaching Note: DaimlerChrysler had to deal with the challenges that were created partly by its failed diversification efforts. The firm faced the task of reversing this strategy, which started with the sale of its electronics operation, divesting a 34 percent stake in Cap Gemini (a French software services company), and liquidating Fokker (a Dutch aircraft manufacturer). The firm also eliminated a layer of upper-level executives and shaped a culture of responsibility and entrepreneurship, with innovation (using cross-functional project teams) as the force supporting the new culture. Uncertain Future Cash Flows Firms also may implement diversification strategies when their products reach maturity (in the product life cycle) or are threatened by external factors that the firm cannot overcome. Thus, firms may view diversification as a survival strategy. In the 1960s and 1970s, railroads diversified because of the threat from the trucking industry to reduce demand for rail transportation. Uncertainty can be derived from supply, demand, and distribution sources. For example, at one time PepsiCo acquired Quaker Oats to fortify its growth with Gatorade and healthy snacks, on the projection that these products would experience greater growth rates than Pepsi’s soft drinks. Synergy and Firm Risk Reduction As you will recall from the discussion earlier in this chapter, firms that diversify in pursuit of economies of scope take advantage of linkages between primary value-creating activities to realize synergy from sharing. Synergy exists when the value created by business units working together exceeds the value the units create when working independently. These linkages—and the inter-relatedness or interdependencies that result—produce joint profitability between business units, and the flexibility of the firm to respond may be constrained, increasing the risk of failure. To eliminate this risk, firms may do one of two things: • Operate in more certain environments to reduce the level of technological change and choose not to pursue potentially profitable, yet unproven product lines • Constrain or reduce the level of activity sharing, thus forgoing the potential benefits of synergy However, these decisions could lead to further diversification • To diversify into industries where more certainty exists • To additional, but unrelated diversification Research suggests that a firm using a related diversification strategy is more careful in bidding for new businesses, whereas a firm pursuing an unrelated diversification strategy may be more likely to overprice its bid, because an unrelated bidder may not have full information about the acquired firm. However, firms using either a related or an unrelated diversification strategy must understand the consequences of paying large premiums. Resources and Diversification In addition to having incentives to diversify, a firm also must possess the correct mix of resources—tangible, intangible, or financial—that makes diversification feasible. However, remember that resources create value when they are rare, valuable, costly to imitate, and nonsubstitutable. In other words, resources that do not have these characteristics can be more easily duplicated (or acquired) by competitors. Thus, it may not be possible to create value using such resources. The excess capacity of tangible resources may be used to justify diversification, especially when the firm sees opportunities for activity sharing. However, value-creation may be possible only in related diversification. Remember, using tangible resources also creates interrelationships through its activity linkages in production, marketing, procurement, and technology, and these interdependencies often reduce firm flexibility and may, in fact, increase the risk of failure. Ideally, as discussed earlier, a firm’s intangible resources—because they are less visible and less understood by competitors—should be used to facilitate and create value from diversification. 7 Describe motives that can encourage managers to overdiversify a firm. VALUE-REDUCING DIVERSIFICATION: MANAGERIAL MOTIVES TO DIVERSIFY Some managers may be motivated to diversify their firms even if there are no incentives, and a lack of resources can constrain inclinations toward diversification. Managers’ motives for diversification include the following: • Diversification may enable managers to reduce employment risk (the risks related to the loss of their jobs or a reduction in compensation) because by diversifying the firm (i.e., by adding a number of additional businesses), managers may be able to diversify their employment risk, as long as profitability does not decline greatly as a result of the diversification. • Diversification allows managers to increase their compensation because of positive correlations between diversification, firm size, and executive compensation (based on the logic that large firms are more difficult to manage). Teaching Note: Indicate to students that corporate governance is covered in much greater detail in Chapter 10. The discussion in this chapter is introductory in nature. If properly structured and used, governance structures—such as the firm’s board of directors, performance monitoring, executive compensation limits, and the market for corporate control—may provide the means to exert control over managers’ tendencies to overdiversify because of self-interest motives. However, if a firm’s internal governance structure is not strong (or functions imperfectly), managers may diversify the firm beyond the optimal level. As a result, the overall firm may fail to earn average returns (illustrated by Figure 6.3). When the internal governance structure fails to restrain managers from overdiversifying (and performance declines), external governance mechanisms, such as the takeover market, may come into play. In the takeover market (also known as the market for corporate control), improved levels of diversification (and improved performance) are achieved by replacing incumbent or current managers and restructuring the firm. However, managers may be able to avoid takeovers through defensive tactics, such as golden parachutes, poison pills, greenmail, or increasing the firm’s leverage ratio. In spite of the preceding comments, most managers take positive strategic actions (such as those related to diversification) that result in overall firm profitability and contribute to the strategic competitiveness of the firm. In addition to the internal and external governance mechanisms discussed, managers also may be provided with incentives to limit firm diversification to optimal levels by a concern for their personal reputations in the labor market and the related market for managerial talent (also known as the market for managers). One signal that the firm may be overdiversified is when operating diversified businesses reduces, rather than improves, the overall performance of the firm. Figure Note: It is useful to note that two factors appearing in Figure 6.4 are discussed in greater detail in future chapters. Governance structures are discussed in Chapter 10 and strategy implementation is covered in Chapter 11. The overall relationship between reasons for diversification, governance, and firm performance is provided in Figure 6.4. FIGURE 6.4 Summary Model of the Relationship Between Diversification and Firm Performance As shown in Figure 6.4, a firm’s diversification strategy is determined by several inter- related factors, • Value-creating influences (economies of scope, market power, financial economics) • Value-neutral influences (resources and incentives) • Value-reducing influences (managerial motives to diversify) • Internal governance • Capital market intervention and the market for managerial talent In turn, the relationship between diversification strategy and firm performance is moderated by: • Capital market intervention and the market for managerial talent with which the diversification strategy is implemented As noted in this chapter, diversification strategies can be used to enhance a firm’s strategic competitiveness and enable it to earn above-average returns. However, positive outcomes from diversification are possible only when the firm achieves the appropriate level of diversification, given its resources, capabilities, and core competencies, and taking into account the external environmental opportunities and threats. Instructor Manual for Strategic Management: Concepts and Cases: Competitiveness and Globalization Michael A. Hitt, R. Duane Ireland, Robert E. Hoskisson 9781285425184, 9781285425177, 9780538753098, 9781133495239, 9780357033838, 9781305502208, 9781305502147
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