Escuela de Administracin

BUSINESS STRATEGY & LEADERSHIP

Corporate Strategy

Pontificia Universidad Catlica de Chile

Matko Koljatic
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The Strategic Management Process

External Analysis Strategic Choice

Mission

Objectives

Strategy Implementation

Competitive Advantage

Internal Analysis

Which Businesses to Enter? Corporate Level Strategy

Diversification Vertical Integration

Levels of Strategy and Organization Structure

Corporate Strategy Corporate Head Office

Competitive Strategy

Division A

Division B

R&D

R&D HR Finance Production Marketing/Sales

Functional Strategies

HR

Finance
Production Marketing/Sales

Competitive vs. Corporate Level Strategy

Key themes in Corporate Strategy

Portfolio Composition
Which value chain activities should we be in?
Horizontal scope: Diversification (Endesa & General Electric cases) Vertical scope: Integration/ Outsourcing (Toyota example)

Portfolio Change
How should we expand (shrink) our portfolio of value chain activities?
Internal development organic growth (Apple case) Alliances (Coors case - Coors / Molson initially) Acquisitions / Divestitures (General Electric case )

Portfolio Organization How do we organize to gain corporate advantage?

Corporate parenting (General Electric & J&J cases) Re-structuring (General Electric case)
1 2 3 4 5 6 7

Logic of Corporate Level Strategy

Corporate level strategy should create value:
1) Absent capital market imperfections, corporate advantage the improvements in profits from creating a portfolio of businesses over and above the profits of the same businesses operating individually must rest on some form of economies of scope (synergies), such that businesses forming the corporation have: a higher Value than they would have under independent ownership (V1;V2 < V1+V2), because of synergies in revenues (Y1; Y2 < Y1 + Y2) and or lower costs ( C1+ C2 < C1; C2) 2) This higher Value can not be created by equity holders 6 through portfolio investing (next slide)

Horizontal Synergies Across Value Chains

PURCHASE

R&D

MANUFAC.

SALES & DIST.

PURCHASE

R&D

MANUFAC.

SALES & DIST.

Value of Diversification
Business X

+ Business Y

+ Business Z

Value

Independent: equity holder could buy shares of each firm only risk reduction is captured by equity holders.

Focal Firm
Business X Economies Of Scope Business Y Business Z
Combined: equity holder buys shares in one firm. Most economies of scope cannot be captured 8 of by equity holders. If a corporate diversification move is unlikely to generate valuable economies scope, managers should avoid it.

Value

Types of Economies of Scope (Synergies)

In general, Economies of Scope occur when the firm achieves cost reductions and/or revenue enhancement (i.e. cross selling) by operating two or more firms

Operational
Sharing Activities: reducing costs by exploiting efficiencies of sharing business activities in the value chain of two firms. Example: CCU Transportes Spreading Core Competencies: reducing costs or enhancing revenue by exploiting resources and capabilities which are strategically relevant in other businesses (Banks)

Financial
Tax Advantages: Reducing costs by taking advantage of differentials in tax rates between countries or regions; transfer pricing policy allows profits in one division to be offset by losses in another division. This is especially true internationally and can be used to smooth income Example: Puerto Rico, Ireland and other tax havens. Internal Capital Market : Capital cost reductions; premise: insiders can allocate capital across divisions more efficiently than the external capital market (banks and institutional investors). Works only if managers have better information than the market. Risk reduction: counter cyclical businesses may provide decreased overall risk thus, lower costs. However, individual investors can usually do this more efficiently than a firm (CCU- VSP)

Anticompetitive
Multipoint Competition: mutual forbearance enhances revenue; a firm chooses not to compete
aggressively in one market to avoid competition in another market (Unilever vs. P&G Market Power: using profits from one business to compete in another business or by using buying power in one business to obtain advantage in another business cost reductions 9

Two Problems with Diversification

HQ Bureaucratic costs
Whether HQs is creating or destroying value is typically hard to tell (or do anything about)
except in the most obvious cases However, markets are distrustful of Corporations which own multiple businesses and undervalue their shares there is a lot of evidence of the conglomerate discount Corporate HQ has a better chance of creating (or destroying) value during periods of change than during steady state periods

HQ Costs
No revenues & overhead (bureaucratic costs: i.e. corporate reporting requirements) Lack of close knowledge of businesses Encourages gaming behaviour by division managers

HQ Benefits
Investment banker/consultant role Resources & Capabilities: Infrastructure, R&D, etc. Superior management skills/ business model Enable collaboration between units

Managerialism (Agency Problems)

Economy of scope that accrues to managers at the expense of equity holders. Managers
of larger firms receive more compensation (larger size = more compensation). Therefore, managers have an incentive to acquire other firms and become ever larger. As the incentive could be there, it is difficult to know if Managerialism is the reason for an 10 acquisition

http://www.quinenco.cl/pdf/presentation/Presentation_Quin enco_Santander_January_2011.pdf

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Corporate Advantage
Happens if a Corporate Strategy meets the VRIO criteria Is it Valuable? Is it Rare? Is it costly to Imitate? Is the firm Organized to exploit it?

it may create a corporate advantage.

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The Strategic Management Process

External Analysis Strategic Choice

Mission

Objectives

Strategy Implementation

Competitive Advantage

Internal Analysis

Which value chain activities should we be in? Corporate Level Strategy

Vertical Integration

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Vertical Synergies Across Value Chains

The Logic of Value Chain Economies

Upstream

If the focal firm is able to create synergy with the other firm(s) in the value chain through:
Downstream
cost reductions

revenue enhancement (cross selling)

the

focal firm is able to capture above normal economic returns

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Vertical Integration Profile

(GM and Ford vs. Toyota)
Arms-length (Independent) Suppliers 25%

Percent of Total Component Costs

Arms-length Suppliers 35% Partner Suppliers* 10% Internally Manufactured

Partner Suppliers* 48%

55%
* 2 or less suppliers for a product category

Internally Manufactured 27%

General Motors and Ford

Toyota
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Source: Jeff Dyer, Collaborative Advantage, Oxford Press 2000

Value of Vertical Integration

Market vs. Integrated Economic Exchange
markets and integrated hierarchies (corporations) are forms in which economic exchange can take place
economic exchange should be conducted in the form that maximizes value for the focal firm thus, firms assess which form is likely to generate more value

Integration makes sense when the focal firm can capture more value than a market exchange provides
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The Theory of Firm Boundaries

Ronald Coase, won the Nobel Prize in Economic

Sciences in 1991 for the theory of firm boundaries Coases question: Why do firms exist at all ? (instead of a series of contracts between individuals who do what they have competitive advantage at). Why are some economic activities performed within firms and others within markets? Answer: Integration makes sense when the focal firm can capture more value than a market exchange provides Integration depends on comparison of total costs production costs plus transaction costs the costs of buying the product or service in the market (rather than produce in-house).
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Vertical Integration based on transaction cost considerations

Vertical Integration gains

Transaction costs

Production costs

Procure from Market

In-house production

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Examples of Transaction Costs:

Costs of guarding against opportunistic behaviour by vendor
Finding reliable vendors Drafting contracts Enforcing contracts Dispute resolution Monitoring mechanisms

Costs of managing interactions with a (remote) vendor that would have occurred naturally in-house
Travel (Tele) communications Coordination mistakes Knowledge acquisition and transfer

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Value of Vertical Integration:

Three Value Considerations Regarding Internalizing
Favor Vertical Integration
Does Not Favor Vertical Integration

Leverage Capabilities firm capabilities may be sources of competitive advantage in other businesses if not, then dont integrate vertically

Manage Opportunism opportunism may be checked by vertical integration

Exploit Flexibility vertical integration is usually less flexible

internalizing must flexibility is be less costly than valuable when uncertainty is opportunism 20 high

International Expansion
The Cost Control Tradeoff
Cost (Capital at Risk) High Greenfield Investment Acquisition

Vertically Integrated

Strategic Alliance
Franchising Licensing Exporting Low

Somewhat Vertically Integrated

Control
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Not Vertically Integrated

High

The Strategic Management Process

External Analysis Strategic Choice

Mission

Objectives

Strategy Implementation

Competitive Advantage

Internal Analysis

Which value chain activities should we be in?

Corporate Level Strategy Diversification

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Types of Corporate Diversification

At a general level Product Diversification:
operating in multiple industries

Geographic Market Diversification:

operating in multiple geographic markets

Product-Market Diversification
operating in multiple industries in multiple geographic markets

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Types of Corporate Diversification

At a more specific level
Limited Diversification
single business: > 95% of sales in single business dominant business: 70% to 95% in single business

Related Diversification
related - all businesses related on most activities in the value chains linked - some businesses related on some activities

Unrelated Diversification
businesses are not related Group or Conglomerate
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Three key questions when diversifying

Is this a good industry to be in?
The structural attractiveness of the industry PEST, 5 Forces+ Complementors, Life Cycle (Endesa case)

Would we enjoy a competitive advantage in this industry?

What is the NPV of investment in equity in other firm (Endesa case)

Would the gains from being in both businesses outweigh the cost of entry?
Acquisition premium (premium over market price of shares) vs. the cost of internal development Are there any synergies with current business

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Its 1970...

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The great diversification boom: 1950-1975: Fortune 500

70.2 63.5 53.7 46.3 36.5 29.8 60.1 53.9 46.1 39.9 37.0 63.0

1949

1954

1959

1964

1969

1974

Percentage of Specialized Companies (single-business, verticallyintegrated and dominant-business)

Percentage of Diversified Companies (related-business and unrelated business) 27

Why did it happen?

Good economic conditions - companies emphasized growth over profitability The rise to eminence of consulting firms

The spread of the M-form (multi-divisional structure) Portfolio management techniques The belief in generic management techniques and skills

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Is this statement true?

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Portfolio Planning Models: The GE/ McKinsey Matrix

Business unit position Low Industry Attractiveness Low Medium High Medium High

Industry Attractiveness Criteria

Market size Market growth Industry profitability Inflation recovery Overseas sales ratio

Business Unit Position Criteria

Market share (domestic, global, and relative) Competitive position Relative profitability
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Portfolio Planning Models:

The BCG Growth-Share Matrix
HIGH
Annual real rate of market growth (%)
Earnings: high stable, growing Cash flow: neutral Strategy : invest for growth Earnings: low, unstable, growing Cash flow: negative Strategy : analyze to determine whether business can be grown into a star, or will degenerate into a dog

???
Earnings : high stable Cash flow: high stable Strategy : milk Earnings : low, unstable Cash flow: neutral or negative Strategy : divest

LOW HIGH Relative market share LOW

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Portfolio Planning Models: Applying the BCG Matrix to a Foods company

Annual real rate of market growth (%)

Strategy: invest for growth

Frozen food division Health foods division

Strategy: analyze to determine whether business can be grown into a star, or will degenerate into a dog

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Strategy: divest
2

Strategy: milk
Fruit juices division Bakery division
0 -2

1.5

0.5

0.1

Relative market share

Current position
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Do Portfolio Planning Models Help or Hinder Corporate Strategy Formulation?

ADVANTAGES
Simplicity (?) & Big picture Analytically versatile

DISADVANTAGES
Sensitive to market definition Ignores Resources & Capabilities Ignores synergies Reduces investments in Cash Cows; invests in business in which Cos may not have Competitive Advantages Ignores financing from capital markets
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Re-focusing in the 80s.

Drop in diversification index of Fortune 500 by 33% between 1980-1990

The most diversified companies became less diversified.

While M&A levels were high, divestments were higher

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Why did this happen?

Goals shifted from growth to profitability as economic conditions tightened. Shareholder activism and shareholder value ideology (Finance professors made their mark !) Innovations in debt financing (LBO= Leveraged Buy Outs) Turbulent market conditions expose weaknesses of large bureaucracies

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Corporate Strategy in the 90s

Distinguishing related from unrelated diversification not all diversification is bad. The Theory of Resource Advantage: resources and capabilities are a source of advantage both at the competitive and corporate level Multiple alternatives for entering new businesses-alliances, M&A (Mergers and Acquisitions), JVs (Joint Ventures), etc. Organizational economics: economies of scope

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What makes for successful corporate strategy?

Porter (87) Attractiveness Cost of entry Better off (next slide) Montgomery and Collis(98) The companys businesses must not be worth more to another buyer

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Porters better off test

Integration between HQ-division

Restructuring
Transferring Intangible assets

Sharing Tangible assets

Portfolio

Integration between divisions

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Market Activated Corporate Strategy (MACS): Who is the Best Owner McKinsey in the 21st Century
Natural Owner Parents Company ability to extract value from the business unit, relative to other potential owners

One of the Pack

HI Medium Low

Business units value creation potential as a stand alone enterprise

Business units (radius denotes 39 value added)

Diversification: some reflections

Diversification into related businesses can add value Relatedness can be measured in the How (i.e. the value chain) , Who (cross selling) or What (i.e. manufacturing, branding, etc.) Understand the sources of synergies and implications for management, risk, regulation How will external stakeholder react? (remember LAN TAM) Even with a good diversification strategy, you can end up with egg on your face
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Thus, after decades of research the overwhelming conclusion must be that M&A activity, on average, does not positively contribute to an acquiring firms performance.

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How should we expand (shrink) our portfolio of value chain activities?

Entering new businesses/scaling up current ones

Inorganic Growth

Organic Growth
New product development, Internal corporate ventures

Non-equity alliances

Acquisitions

Equity alliances

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Organic (Internal) vs. Inorganic (Diversification) development

Need for speed favours inorganic growth organic growth is slow and uncertain Availability of related resources and capabilities within the company to build on favours organic growth Market maturity - prospective acquisitions to gain market share favors inorganic growthespecially in geographic diversification Regulation can sometimes force divestitures because of antitrust restrictions (i.e. Copec Terpel)
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Organic Growth
Advantages
incremental compatible with organizational culture Promotes intrapreneurship Internal investment

Disadvantages
slow Forces to develop new resources and capabilities Increases installed capacity; entry may not be at scale size Failures are not recoverable
44 Matko Koljatic

Mergers and Acquisitions

Advantages
Eliminates competitors Synergies in revenues (cross selling) and costs (less duplications) easy to assess Fast Access and Upgrade of complementary Resources and Capabilities

Disadvantages
Cost of acquisition (premium) Bureaucratic costs Acquisition of resources which are not needed Organizational conflicts may occur Commitment of large resources - risk
45 Matko Koljatic

Alliances
Advantages
Access to complimentary resources revenue enhancement (OneWorld) Fast

Disadvantages
Lack of control Helps a competitor too Long term viability, questionable Difficulty in integration and learning
46 Matko Koljatic

Summary
Corporate Strategy: In what businesses should the firm operate?
an understanding of diversification helps managers answer that question

Two Criteria:
1) economies of scope must exist 2) must create value that outside equity holders cannot create on their own
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Summary
Economies of Scope
a case of synergycombined activities generate greater value than independent activities
may generate competitive advantage if they meet the VRIO criteria

Firms should pursue diversification only if careful analysis shows that corporate advantage is likely!
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