Chapter 10: Corporate Strategy: Diversification, Acquisitions, and Internal New Ventures 1
CHAPTER 10
Corporate Strategy: Diversification, Acquisitions, and Internal New Ventures
Synopsis of Chapter
This chapter continues the discussion of corporate strategy that was begun in Chapter 9. Diversification into more than one business is the corporate-level strategy for growth. The corporation is treated as a portfolio of investments, and diversification is seen as a way of further leveraging the firm’s distinctive competencies. The role of diversification in increasing firm profitability, through transferring or leveraging competencies, sharing resources, managing multipoint competition, or leveraging general organizational competencies, is also discussed.
Next, the chapter deals with related and unrelated diversification, the advantages and disadvantages of each strategy. The limits of diversification are also described, including an extensive treatment of bureaucratic costs. The chapter continues with a discussion of diversification efforts that lead to value dissipation, rather than value creation.
The remainder of the chapter describes three entry strategies for diversification: internal new ventures, acquisitions, and joint ventures. In each section, the benefits and challenges of that entry strategy are listed, along with suggestions about how to increase the chances of a successful implementation of that strategy. Finally, diversification’s opposite, restructuring, is introduced and several exit strategies are described.
Teaching Objectives
1.Introduce students to concepts related to diversification, including the reasons why firms pursue diversification.
2.Describe related and unrelated diversification and the benefits and problems associated with each.
3.Summarize the limits of diversification with a focus on bureaucratic costs, and show how diversification can lead to value dissipation, rather than value creation.
4.Describe benefits, challenges, and implementation guidelines for the corporate-level strategy of internal new ventures.
5.Describe benefits, challenges, and implementation guidelines for the corporate-level strategy of acquisitions.
6.Describe benefits, challenges, and implementation guidelines for the corporate-level strategy of joint ventures.
7.Discuss the reasons why firms restructure, and illustrate several exit strategies.
Opening Case: Tyco International
From 1996 to 2001, the conglomerate Tyco International expanded rapidly, acquiring over 100 diverse businesses. Tyco’s business model is to seek to consolidate a previously fragmented industry in each of the industries in which it competes. Also, Tyco refuses to enter into risky hostile takeovers, instead looking for companies that make basic products and have a strong market presence, but are less profitable than their peers. The firm thoroughly investigates each potential target and replaces top managers with its own team. After acquisition, cost cutting becomes the focus, with incentives for executives whose units reach earnings objectives.
Tyco’s stock underperforms, because investors are put off by the complexity of its financial reporting and its heavy debt burden. Rumors that Tyco was conspiring with managers of the acquired firms to inflate Tyco’s performance persist. CEO Kozlowski resigned after being charged with tax evasion. John Fort, the new CEO, spun off Tyco’s finance division, and used the cash to pay down debts. Whether he can find a source of continuing profitability remains to be seen.
Teaching Note: This case tells how Tyco’s acquisition strategy both brings benefits to the firm, as well as introduces some potential weaknesses. For example, the very success of its acquisition strategy led to the high debt that brought the stock price down. An interesting discussion for your class could be started, based on questions about Tyco’s ethics. Persistent rumors of financial misdeeds, a CEO charged with tax evasion, and obscure financial reporting all seem to point to ethical problems at Tyco. Do your students think that Tyco does in fact have an unethical organization culture? If no, how do they explain the rumors? If yes, can outside observers (for example, potential investors) determine the nature of the ethical issues, and how?
Lecture Outline
I.Overview
A.This chapter is the second chapter that deals with corporate strategy, and focuses on diversification, the process of adding new businesses to the company that are distinct from its established operations. Thus, a diversified company is involved in two or more distinct businesses.
B.Another focus is on the execution of a diversification strategy. This might take place through internal new venturing, which is starting a business from scratch; acquisition, or buying an existing business; and joint ventures established with the help of a partner.
C.A third topic is restructuring, the opposite of diversification, in which a company reduces the scope of its operations by exiting industries.
II.Expanding Beyond a Single Industry
A.Corporate-level managers identify which industries a company should compete in to maximize long-run profitability.
1.Often, it is better to compete within a single industry.
a.One advantage of a single business corporation is the ability to focus more resources and attention on that one area.
b.Another advantage is that a firm sticks with what it knows and does best, and does not risk making the mistake of moving into areas in which it has no distinctive competencies.
2.There are also disadvantages to a single-business strategy.
a.One disadvantage is the increased risk that comes from tying corporate profitability to just one industry.
b.Another disadvantage is that a firm may miss out on opportunities to further leverage its distinctive competencies.
B.One model of a corporation looks at the firm as a portfolio of distinctive competencies, rather than a portfolio of products. Managers can then consider how to leverage those competencies.
C.Hamel and Prahalad claim that, once a firm has identified its current competencies, it should use a matrix, such as the one presented in Figure 10.1, to establish an agenda for building and leveraging competencies to create new businesses.
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Figure 10.1: Establishing a Competency Agenda
1.The lower left corner of the matrix represents the company’s current portfolio of competencies. This quadrant is called “fill-in-the-blanks” because the recommended strategy here is to transfer existing competencies in order to improve its position in existing industries.
2.The upper left matrix quadrant is called “premier plus 10,” to suggest that managers must be building new competencies today to ensure that the firm is a premier provider ten years from now.
3.The lower left quadrant is “white spaces,” and it indicates the firm’s search for new industries where its existing distinctive competencies could be deployed through diversification.
4.The upper left quadrant is referred to as “mega-opportunities,” and it represents opportunities for entry into new industries where the company currently has none of the required competencies.
5.Use of this matrix helps managers think strategically about competencies and industries as they change over time. Managers who use this matrix will be unlikely to enter new markets where they do not have a competitive advantage.
D.Companies that wish to expand beyond a single industry must develop their business model at two levels.
1.First, they must develop a business model for each industry in which they plan to compete.
2.Then, the company must develop a higher-level multibusiness model that justifies entry into different industries in terms of profitability. This model should describe how the firm plans to leverage its distinctive competencies across industries. The model must also describe how the business and corporate strategies boost profitability.
III.Increasing Profitability Through Diversification
A.Diversification is the process of adding new businesses to the company that are distinct from its established operations. Thus, a diversified company is involved in two or more distinct businesses.
B.To increase profitability, diversification should allow the company to lower costs, differentiate its products, or better manage industry rivalry.
C.When the firm is generating free cash flow, that is, profits about the level necessary to meet current expenses and obligations, the firm’s managers may choose to return dividends to shareholders or to invest the cash in diversification.
D.For diversification to make economic sense, the expected return on invested capital (ROIC) from the diversification must exceed the returns shareholders could realize through investing that capital in a diversified investment portfolio.
1.One way that firms use diversification to boost profitability is through their ability to transfer their existing distinctive competencies to an existing business in another industry. The transfer must involve competencies that are important for competitive advantage in that business.
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Figure 10.2: Transfer of Competencies at Philip Morris
2.Another way of boosting profitability requires that the company leverage its existing distinctive competencies by using them to create a new business in a different industry.
a.Leveraging competencies involves creation of a new business, whereas transferring competencies involves an existing business. This distinction is important because the two different situations require the use of different managerial skills.
b.Companies that leverage competencies tend to use R&D skills to build a new venture in a technology-related industry, whereas companies that transfer competencies tend to acquire established businesses.
Strategy in Action 10.1: Diversification at 3M: Leveraging Technology
3M is known for its ability to generate new products and new businesses—30 percent of its sales come from products developed during the last five years. The company is consistently able to extend an existing technological competency to making a similar yet innovative product. Their success is due to a variety of factors, including a culture that encourages risk taking, a focus on solving customer problems, the use of stretch goals, and employee autonomy to pursue their own ideas. Also important are the firm’s system for sharing technologies and expertise and a reward structure that recognizes innovators.
Teaching Note: This case provides an example of a firm that is skilled at leveraging existing competencies into the creation of new businesses, but it’s especially useful that the specific mechanisms for encouraging innovation are described in detail. Ask students to consider how another company with which they are familiar might use some or all of 3M’s strategies for improving innovation. What would be some likely results?
3.Another way to use diversification to increase profitability is through sharing resources across multiple businesses in order to obtain cost reductions. This sharing is called economies of scope.
a.Economies of scope occur because each business can invest less in the shared resource than in resources that are not shared.
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Figure 10.3: Sharing Resources at Procter & Gamble
b.Economies of scale generate economies of scope, because resource sharing allows the company to use the resource more intensively.
c.Economies of scope are obtained only when there is significant commonality between one or more value creation functions in the two businesses.
d.Also, managers must weigh the benefits obtained by resource sharing against the increased bureaucratic costs of doing so.
4.Diversification can also boost profitability by enabling the company to better manage rivalry through the use of multipoint competition.
a.Multipoint competition occurs when two companies rival each other in more than one industry.
b.The threat of increasing competitive rivalry in one industry can keep a competitor from entering another industry or can cause the competitor to lessen the intensity of competitive pressure.
5.A final way that profitability can increase due to diversification is through the improved use of general organizational competencies, that is, corporate-level competencies that transcend individual functions or businesses.
a.General organizational competencies require the use of rare managerial skills and are difficult to develop and implement.
b.One general organizational competency is an entrepreneurial capability, which allows managers to recognize and develop new businesses internally. Companies with this competency are skilled at encouraging risk taking while also limiting the amount of risk undertaken.
c.Another general organizational competency is the ability to develop effective organization structure and controls.
(1)Effective structure and controls encourage business-level managers to maximize efficiency and effectiveness, increasing profitability.
(2)Companies with effective structure and controls tend to use self-contained business divisions.
(3)Companies with effective structure and controls tend to be decentralized.
(4)Companies with effective structure and controls tend to link pay to performance.
d.Another general organizational competency is a superior strategic capability, such that top managers have good governance skills and can effectively manage the firm’s business-level managers.
(1)One aspect of superior strategic capability is a flair for entrepreneurship.
(2)Superior strategic capability also expresses itself in an ability to recognize ways to improve the performance of individuals, functions, and businesses.
(3)Another aspect of effective governance is the ability to diagnose the real source of problems and then to know the appropriate steps to take to fix those problems.
(4)Superior strategic capability is at work when a diversified company acquires a new business and then restructures it to improve performance.
IV.Types of Diversification
A.Related diversification moves the company into a new activity that is linked to its existing activity by a commonality between value chain activities.
1.Typically, the commonality lies in the manufacturing, marketing, and technology functions.
2.Typically, firms pursing a strategy of related diversification expect to benefit from transferring and leveraging competencies and from sharing resources.
3.Also, companies pursing a strategy of related diversification are likely to encounter their rivals in several related industries and thus are likely to benefit from managing that rivalry through multipoint competition.
Strategy in Action 10.2: Related Diversification at Intel
Intel’s operations have been focused on microprocessors for personal computers, but when executives realized that PC sales were reaching saturation and that communications would likely be the next high-growth industry, they turned the company’s attention to developing semiconductors for the communications industry. This switch would allow the company to leverage their technological know-how more fully. From 1997 to 2001, Intel acquired 18 chipmakers and moved into fourth place in the industry, spending a total of $18 billion. Unfortunately, the communications industry slumped and the business became a money-loser. In contrast, its PC chips are still highly profitable and its competition position in that industry seems assured.
Teaching Note: This case gives an example of a not very successful foray into related diversification. Although Intel executives expected to be able to leverage their competencies, the firm is still in a weak position in the communications industry. You can use this case to illustrate the difficulties in identifying businesses that have enough commonality to allow for successful leveraging of competencies. Also, now is a good time to ask students for creative suggestions for related diversification in other firms. You can ask them, “What businesses are good candidates for related diversification by Exxon?” “by Disney?” “by Wal-Mart?” and so on. As students debate the merits of different potential targets, they will come to realize how difficult identifying a good target can be.
B.Unrelated diversification moves the company into a new activity that has no obvious commonalities with any of the company’s existing activities.
1.Typically, firms expect to benefit from unrelated diversification through the exploitation of general organizational competencies.
2.Typically, firms pursuing unrelated diversification are unlikely to meet their rivals in more than one industry, and thus are unlikely to benefit from managing rivalry through multipoint competition.
V.The Limits of Diversification
A.Diversification, in many cases, can dissipate value instead of creating it.
1.Although related diversification has more ways to increase profitability and seems to involve fewer risks, research has shown that related firms achieve profits that are only slightly higher than unrelated firms.
2.Firms that are extensively diversified, with many businesses, tend to be less profitable.
3.A study by Michel Porter found that over time, companies divested many more of their acquisitions than they kept.
B.One reason for the failure of diversification to achieve its goals is that the bureaucratic costs of diversification exceed the value created by it.
1.The level of bureaucratic costs is a function of the number of businesses in a company’s portfolio.
a.The greater the number of businesses, the more difficult it is for managers to remain informed about the complexities of each business. They simply do not have the time to process all the information.
(1)Therefore, corporatelevel managers end up making important decisions based on a superficial analysis of each business.
(2)Corporate managers’ lack of familiarity with operations increases the probability that businesslevel managers will be able to distort information provided to those at the corporate level.
b.Thus, information overload can result in substantial inefficiencies within extensively diversified companies.
c.In order to overcome information overload, some corporate managers limit the extent of diversification at their firms.
2.Another source of bureaucratic costs is the coordination required to realize value from transferring competencies and resource sharing.
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Figure 10.4: Coordination Among Related Business Units
a.Bureaucratic costs arise from an inability to identify the unique profit contribution of a business unit that is sharing resources and functions with another unit.
b.This problem can be resolved if corporate management directly audits both divisions, however, doing so requires both time and effort from corporate managers.
c.The accountability problem is far more serious at companies that are extensively diversified. Information overload occurs and corporate management effectively loses control of the company.
3.Thus, bureaucratic costs, which increase as a function of the number of businesses and the extent of resource sharing, place a limit on the value created by diversification. If a company continues to diversify after the point at which costs exceed benefits, profitability will decline. Then, divestment is the best solution.