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Strategic Management:

Creating Competitive Advantages


Gregory G. Dess G. T. Lumpkin Theodore Peridis

Canadian Edition

Part 2: Strategic
Formulation

Chapter 6
Corporate-Level Strategy: Creating Value through Diversification
STRATEGIC MANAGEMENT McGraw-Hill Ryerson
Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Learning Objectives
After reading this chapter, you should have a good understanding of:
1. Why firms engage in diversification efforts and how managers can create value through diversification initiatives. 2. How corporations can use related diversification to achieve synergistic benefits through economies of scope and market power.

Copyright 2006 by McGraw-Hill Ryerson, Inc. All rights reserved.

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Learning Objectives
After reading this chapter, you should have a good understanding of:
3. How corporations can use unrelated diversification to achieve synergistic benefits trough corporate restructuring, parenting, and portfolio analysis. 4. The various means of engaging in diversification: mergers and acquisitions, strategic alliances and joint ventures, internal development.
Copyright 2006 by McGraw-Hill Ryerson, Inc. All rights reserved.

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Learning Objectives
After reading this chapter, you should have a good understanding of:
5. The value of real options analysis (ROA) in making resource allocation decisions under conditions of high uncertainty. 6. The reason for the failure of many diversification efforts.

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Making Diversification Work


What businesses should a corporation compete in? How should these businesses be managed to jointly create more value than if they were freestanding units?

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Making Diversification Work


Diversification initiatives must create value for shareholders
Mergers and acquisitions Strategic alliances

Joint ventures
Internal development

Diversification should create synergy

Business 1
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Business 2

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Key issues corporate versus business strategy


CORPORATE STRATEGY: How to create a competitive advantage for the whole company What businesses should we be in? How should these be managed? How to create value for the corporation as a whole?

BUSINESS STRATEGY: How to create a competitive advantage in specific, individual product markets Which customers to serve (who?) segmentation Which customers needs to satisfy (what?) differentiation

Resources and value chain activities necessary to satisfying customer needs (how?) core competencies

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Synergy
Related businesses (horizontal relationships)
Sharing tangible resources

Sharing intangible resources


Manufacturing facilities Production facilities Specialized skills Patents, copyrights, etc. Favorable reputation Business 2
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Distribution channels Business 1

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Synergy
Unrelated businesses (hierarchical relationships)
Value creation derives from corporate office

Leveraging support activities


Human resource mgmt
Technology development

Firm infrastructure

Business 2

Procurement

Information systems Business 1

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Creating Value
Related Diversification
Leveraging core competencies 3M leverages it competencies in adhesives technologies to many industries, including automotive, construction, and telecommunications Sharing activities McKesson, a large distribution company, sells many product lines, such as pharmaceuticals and liquor, through its superwarehouses Pooled negotiating power The Times Mirror Company increases its power over customers by providing one-stop shopping for advertisers to reach customers through multiple mediatelevision and newspapersin several huge markets such as New York and Chicago Vertical integration Shaw industries, a giant carpet manufacturer, increases its control over raw materials by producing much of its own polypropylene fiber, a key input to its manufacturing process

Exhibit 6.1 Creating Value through Related and Unrelated Diversification


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Creating Value
Unrelated Diversification: Parenting, Restructuring, and Financial Synergies
Corporate restructuring and parenting The corporate office of Cooper Industries adds value to its acquired businesses by performing such activities as auditing their manufacturing operations, improving their accounting activities, and centralizing union negotiations Portfolio management Novartis, formerly Ciba-Geigy, uses portfolio management to improve many key activities, including resource allocation and reward and evaluation systems

Exhibit 6.1 Creating Value through Related and Unrelated Diversification


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Related Diversification: Economies of Scope and Revenue Enhancement Economies of scope


Cost savings from leveraging core competencies or sharing related activities among businesses in the corporation Leverage or reuse key resources
Favorable reputation Expert staff Management skills Efficient purchasing operations Existing manufacturing facilities

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Leveraging Core Competencies


Core competencies
The glue that binds existing businesses together
Engine that fuels new business growth Collective learning in a firm
How to coordinate diverse production skills How to integrate multiple streams of technologies How to market diverse products and services

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Three Criteria of Core Competencies


Superior Customer value

Three criteria (of core competencies) that lead to the creation of value and synergy Core competencies must enhance competitive advantage(s) by creating superior customer value Develop strengths relative to competitors

Build on skills and innovations


Appeal to customers

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Three Criteria of Core Competencies


Superior Customer value

Three criteria (of core competencies) that lead to the creation of value and synergy Different businesses in the firm must be similar in at least one important way related to the core competence Not essential that products or services themselves be similar

Businesses similar in way related to core competency

Is essential that one or more elements in the value chain require similar essential skills
Brand image is an example
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Three Criteria of Core Competencies


Superior Customer value

Three criteria (of core competencies) that lead to the creation of value and synergy Core competencies must be difficult for competitors to imitate or find substitutes for Easily imitated or replicated core competencies are not a sound basis for sustainable advantages Specialized technical skills acquired only in company work experience are an example
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Businesses similar in way related to core competency

Difficult to imitate or find substitutes for

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Sharing Activities
Corporations can also achieve synergy by sharing tangible and value-creating activities across their business units
Common manufacturing facilities Distribution channels Sales forces

Sharing activities provide two payoffs


Cost savings Revenue enhancements

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Cost Savings through Sharing Activities


Most common type of synergy

Savings obtained through


Eliminating duplicate jobs Eliminating duplicate facilities

Eliminating related expenses

Savings may be offset by


Greater costs of coordinating shared activities

Costs of compromising design or performance of a shared activity

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Enhancing Revenue through Sharing Activities


Acquiring firm and its target may achieve a higher level of sales growth together than either could have achieved on its own
Combined distribution channels can escalate sales of the acquiring companys products Enhanced effectiveness of differentiation strategies

Can have a negative effect on a given businesss differentiation

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Pooled Negotiating Power


Similar businesses working together can have stronger bargaining position relative to
Suppliers Customers Competitors

Bargaining Bargaining Bargaining power power power


Business 1 Business 2

Abuse of bargaining power may affect relationships with customers, suppliers and competitors

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Vertical Integration
Benefits
Dependency Suppliers Customers Business 2
Dependency

Secure source of supply of raw materials Secure distribution channels Protection and control over assets and services Access to new business opportunities and technologies Simplified procurement and administrative procedures

Dependency Suppliers Customers


Business 1

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Vertical Integration
Risks
Costs and expenses associated with increased overhead and capital expenditures
Dependency

Business 2

Loss of flexibility resulting from inability to respond quickly to changes in the external environment Problems associated with unbalanced capacities or unfilled demand along the value chain Additional administrative costs

Business 1

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Vertical Integration: Benefits and Risks


Benefits A secure source of raw materials or distribution channels. Protection of and control over valuable assets. Access to new business opportunities Simplified procurement and administrative procedures. Risks
Costs and expenses associated with increased overhead and capital expenditures Loss of flexibility resulting from large investments. Problems associated with unbalanced capacities along the value chain. Additional administrative costs associated with managing a more complex set of activities.

Exhibit 6.3 Benefits and Risks of Vertical Integration


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Vertical Integration
In making decisions associated with vertical integration, four issues should be considered
1. Are we satisfied with the quality of the value that our present suppliers and distributors are providing? 2. Are there activities in our industry value chain presently being outsourced or performed independently by others that are a viable source of future profits? 3. Is there a high level of stability in the demand for the organizations products? 4. How high is the proportion of additional production capacity actually absorbed by existing products or by the prospects of new and similar products?

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Analyzing Vertical Integration: The Transaction Cost Perspective


Negotiating costs Search costs

Search costs

Market transaction

Negotiating costs

Enforcement costs Monitoring costs

Costs of written contract

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Unrelated Diversification: Financial Synergies and Parenting


Most benefits from unrelated diversification are gained from vertical (hierarchical) relationships
Parenting and restructuring of businesses

Allocate resources to optimize


Profitability cash flow Growth

Appropriate human resources practices Financial controls


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Corporate Parenting
Corporate office

Parentingcreating value within business units


Experience of the corporate office

Plans Budgets Support of the corporate Procurement Legal functions office Financial functions Human resource management Business unit Business unit Business unit

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Corporate Restructuring
Corporate office

Find poorly performing firms


With unrealized potential

Sell off parts Reduce payroll On threshold of Change strategies Change management significant positive Infuse new technologies Reduce unnecessary expenses change Business Business unit unit Business Business unit unit Business Business unit unit

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Corporate Restructuring

Corporate management must


Have insight to detect undervalued companies or businesses with high potential for transformation
Have requisite skills and resources to turn the businesses around

Restructuring can involve changes in


Assets

Capital structure
management

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Portfolio Management

Key
Each circle represents one of the firms business units Size of circle represents the relative size of the business unit in terms of revenue

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Portfolio Management
Creation of synergies and shareholder value by portfolio management and the corporate office
Allocate resources (cash cows to stars and some question marks) Expertise of corporate office in locating attractive firms to acquire

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Portfolio Management
Creation of synergies and shareholder value by portfolio management and the corporate office
Provide financial resources to business units on favorable terms reflecting the corporations overall ability to raise funds

Provide high quality review and coaching for units


Provide a basis for developing strategic goals and reward/evaluation systems
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Means to Achieve Diversification


Acquisitions or mergers

Pooling resources of other companies with a firms own resource base


Joint venture

strategic alliance

Internal development
New products

New markets
New technology

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Mergers and Acquisitions


Value Created Value Destroyed

Deal

Year Since Combination Since Combination


$ 12.7 billion _____ _____ _____ _____ _____ $ 8 billion _____ _____ $109 billion _____ _____ $148 billion $299 billion $78 billion $40 billion $26 billion _____ $68 billion $94 billion _____ $36 billion

Manulife/John Hancock 2003 AOL/Time Warner 2001 Vodafone/Mannesmann 2000 Pfizer/Warner-Lambert 2000 Glaxo/SmithKline 2000 Chase/J. P. Morgan 2000 Exxon/Mobil 1999 SBC/Ameritech 1999 WorldCom/MCI 1998 Travelers/Citicorp 1998 Daimler/Chrysler 1991

Source: K. H. Hammonds, The Numbers Dont Lie, Fast Company, September 2002, p. 80. and Thomson Datatream

Exhibit 6.2 Ten Biggest Mergers and Acquisitions of All Time and Their Effect on Shareholder Wealth
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Strategic Alliances and Joint Ventures


Entering new markets

Introduce successful product or service into a new market


Lacks requisite marketing expertise

Doesnt understand customer needs Doesnt know how to promote the product Doesnt have access to proper distribution channels

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Strategic Alliances and Joint Ventures


Entering new markets

Join other firms to reduce manufacturing (or other) costs in the value chain
Pool capital

Reducing costs in value chain

Pool value-creating activities


Pool facilities

Economies of scale

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Strategic Alliances and Joint Ventures


Entering new markets

Develop or diffuse new technologies


Use expertise of two or more companies Develop products technologically beyond the capability of the companies acting independently

Reducing costs in value chain

Developing diffusing new technology

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Unmet Expectations: Strategic Alliances and Joint Ventures


Improper partner
Each partner must bring desired complementary strengths to partnership
Strengths contributed by each should be unique

Partners must be compatible

Partners must trust one another

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Real Options Analysis


Stock options (financial assets)

Real options ( real assets or physical things)


Investments can be staged Strategic decision-makers have tollgates Increased knowledge about outcomes at the time of the next investment decision

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Managerial Motives Can Erode Value Creation


Growth for growths sake

Egotism
Antitakeover tactics
Greenmail
Golden parachute Poison pills

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