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 over diversify a firm. CHAPTER OUTLINE Opening Case: Disney Adds Value Using a Related Diversification Strategy LEVELS OF DIVERSIFICATION Low Levels of Diversification 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: GE and United Technology are Firms that Have Pursued Internal Capital Allocation and Restructuring Strategies Strategic Focus: Ericsson’s Substantial Market Power VALUE-NEUTRAL DIVERSIFICATION: INCENTIVES AND RESOURCES Incentives to Diversify Resources and Diversification Strategic Focus: Coca Cola’s Diversification to Deal with Its Reduced Growth in Soft Drinks VALUE-REDUCING DIVERSIFICATION: MANAGERIAL MOTIVES TO DIVERSIFY SUMMARY MINI-CASES REVIEW QUESTIONS MINDTAP RESOURCES 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 Disney Adds Value Using a Related Diversification Strategy The Walt Disney Company has pursued a related diversification strategy by using its movies to create franchises and platforms around its popular cartoon and action movie figures. While competitive content providers have weakened to lower TV ratings, Disney was strengthened through its other businesses including consumer products, interactive consumer products, interactive parks and resorts, and studio entertainment parks, and a strong cable franchise. Disney’s strategy is successful because its corporate strategy, compared to its business level strategy, adds value across its set of businesses above what the individual businesses could create individually. In addition, the corporation has broad and deep knowledge about its customers that is a corporate level capability in terms advertising and marketing. This capability allows it to cross sell products highlighted in its movies through its media distribution outlets, parks and resorts, as well as consumer product businesses. Teaching Note While many content creating competitors are facing revenue losses due to lower TV ratings, The Walt Disney Company is growing through a related diversification strategy by using its movies to create franchises and platforms around its popular cartoon and action movie figures. Ask students to evaluate these related franchises and platforms to support its movie content. Why is this strategy successful in creating value?
1 Define corporate-level strategy and discuss its purpose.
Remember that in Chapters 4 and 5 the discussion centered on 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. 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 are used to: • avoid violations of antitrust regulations • take advantage of tax incentives • overcome low performance • reduce the uncertainty of future cash flows • reduce overall firm risk • exploit tangible resources • exploit intangible resources Managerial or value-reducing motives are used to: • diversify managerial employment risk • 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. 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 their business unit support system 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. 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 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. STRATEGIC FOCUS GE and United Technology are Firms that Have Pursued Internal Capital Allocation and Restructuring Strategies 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 Technology 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. United Technologies Corporation, an unrelated firm, has allocated resource internal according to their best and most efficient use. Similar to GE, it often it has bought restructured and operated businesses until it made sense to sell them. United Technologies owns Otis Elevator, building fires and security system brands Chubb and Kidde, Pratt & Whitney jet engines, and Carrier air conditioners besides Sikorsky Aircraft. Both GE and United Technology has used internal capital allocate resources among its diversified business units efficiently. Also, both business have used the restructuring strategy to make their business more efficient and when appropriate sold them on the open market, either through selloff to another acquirer or through spinoffs where two stock prices are created, one for the legacy business and one for the spinoff firm 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 are not 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 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. Because 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 1973–1977 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. Strategic Focus Coca-Cola’s Diversification to Deal with Its Reduced Growth in Soft Drinks Changing consumer tastes have caused The Coca-Cola Company to diversify its drink offerings in order to combat falling revenue and profits, which dropped noticeable from 2013 to 2015. The company is responding to a consumer demand for “healthier, tastier, more unique and less mass market” products. Among its strategies, Coca-Cola launched its “venture and emerging brands” (VEB) to cultivate relationships and ultimately to purchase some of these small start-ups. Through this process, it now owns Fuse Tea, Zibo coconut water, and the organic brand Honest Tea. It has also tinkered with other approaches such as its Freestyle soda fountain machine “that offers more than 100 different drink choices; some, such as Orange Coke, aren’t available in cans.” It now has these drink machines in fast food chains such as Five Guys and Burger King. This approach has consistently raised drink sales by double-digits every year, mostly because the volume is higher. 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 non-substitutable. 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 over diversify 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 over diversify 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 over diversifying (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 over diversified 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 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 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. Mini-Case 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 pump over machinery. Some technologies used in the production and in its products are 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. Instructor Manual for Strategic Management: Concepts and Cases: Competitiveness and Globalization Michael A. Hitt, R. Duane Ireland, Robert E. Hoskisson 9781305502147, 9780357033838
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