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CHAPTER 7
Strategies for Competing in International Markets
Learning Objectives
THIS CHAPTER WILL HELP YOU UNDERSTAND:
LO 1 The primary reasons companies choose to compete in international markets.
LO 2 How and why differing market conditions across countries influence a company’s strategy choices in international markets.
LO 3 The five major strategic options for entering foreign markets.
LO 4 The three main strategic approaches for competing internationally.
LO 5 How companies are able to use international operations to improve overall competitiveness.
LO 6 The unique characteristics of competing in developing-country markets.
© Kenneth Batelman/Ikon Images/SuperStock
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Our key words now are globalization, new products and businesses, and speed.
Tsutomu Kanai—Former chair and president of Hitachi
You have no choice but to operate in a world shaped by globalization and the information revolution. There are two options: Adapt or die.
Andy Grove—Former chair and CEO of Intel
A sharing of control with local partners will lead to a greater contribution from them, which can assist in coping with circumstances that are unfamiliar to the foreign partner.
Yanni Yan—Business author and academic
LO 1
The primary reasons companies choose to compete in international markets.
A company may opt to expand outside its domestic market for any of five major reasons:
1. To gain access to new customers. Expanding into foreign markets offers potential for increased revenues, profits, and long-term growth; it becomes an especially attractive option when a company encounters dwindling growth opportunities in its home market. Companies often expand internationally to extend the life cycle
Any company that aspires to industry leadership in the 21st century must think in terms of global, not domestic, market leadership. The world economy is globalizing at an accelerating pace as ambitious, growth-minded companies race to build stronger competitive positions in the markets of more and more countries, as countries previously closed to foreign companies open up their markets, and as information technology shrinks the importance of geographic distance. The forces of globaliza- tion are changing the competitive landscape in many industries, offering companies attractive new opportunities and at the same time introducing new competitive threats. Companies in industries where these forces are greatest are therefore under con- siderable pressure to come up with a strategy for competing successfully in international markets.
This chapter focuses on strategy options for expanding beyond domestic boundaries and com- peting in the markets of either a few or a great many countries. In the process of exploring these options, we introduce such concepts as multi- domestic, transnational, and global strategies; the Porter diamond of national competitive advantage; and profit sanctuaries. The chapter also includes sections on cross-country differences in cultural, demographic, and market conditions; strategy options for entering foreign markets; the impor- tance of locating value chain operations in the most advantageous countries; and the special cir- cumstances of competing in developing markets such as those in China, India, Brazil, Russia, and eastern Europe.
WHY COMPANIES DECIDE TO ENTER FOREIGN MARKETS
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of their products, as Honda has done with its classic 50-cc motorcycle, the Honda Cub (which is still selling well in developing markets, more than 50 years after it was first introduced in Japan). A larger target market also offers companies the opportunity to earn a return on large investments more rapidly. This can be par- ticularly important in R&D-intensive industries, where development is fast-paced or competitors imitate innovations rapidly.
2. To achieve lower costs through economies of scale, experience, and increased purchasing power. Many companies are driven to sell in more than one country because domestic sales volume alone is not large enough to capture fully econo- mies of scale in product development, manufacturing, or marketing. Similarly, firms expand internationally to increase the rate at which they accumulate experi- ence and move down the learning curve. International expansion can also lower a company’s input costs through greater pooled purchasing power. The relatively small size of country markets in Europe and limited domestic volume explains why companies like Michelin, BMW, and Nestlé long ago began selling their products all across Europe and then moved into markets in North America and Latin America.
3. To gain access to low-cost inputs of production. Companies in industries based on natural resources (e.g., oil and gas, minerals, rubber, and lumber) often find it necessary to operate in the international arena since raw-material supplies are located in different parts of the world and can be accessed more cost-effectively at the source. Other companies enter foreign markets to access low-cost human resources; this is particularly true of industries in which labor costs make up a high proportion of total production costs.
4. To further exploit its core competencies. A company may be able to extend a market-leading position in its domestic market into a position of regional or global market leadership by leveraging its core competencies further. H&M is capitalizing on its considerable expertise in online retailing to expand its reach internationally. By bringing its easy-to-use and mobile-friendly online shopping to 23 different countries, the company hopes to pave the way for set- ting up physical stores in these countries. Companies can often leverage their resources internationally by replicating a successful business model, using it as a basic blueprint for international operations, as Starbucks and McDonald’s have done.1
5. To gain access to resources and capabilities located in foreign markets. An increasingly important motive for entering foreign markets is to acquire resources and capabilities that may be unavailable in a company’s home market. Companies often make acquisitions abroad or enter into cross-border alliances to gain access to capabilities that complement their own or to learn from their partners.2 In other cases, companies choose to establish operations in other countries to utilize local distribution networks, gain local managerial or marketing expertise, or acquire technical knowledge.
In addition, companies that are the suppliers of other companies often expand interna- tionally when their major customers do so, to meet their customers’ needs abroad and retain their position as a key supply chain partner. For example, when motor vehicle companies have opened new plants in foreign locations, big automotive parts suppliers have frequently opened new facilities nearby to permit timely delivery of their parts and components to the plant. Similarly, Newell-Rubbermaid, one of Walmart’s biggest suppliers of household products, has followed Walmart into foreign markets.
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LO 2
How and why differing market conditions across countries influence a company’s strategy choices in international markets.
WHY COMPETING ACROSS NATIONAL BORDERS MAKES STRATEGY MAKING MORE COMPLEX Crafting a strategy to compete in one or more countries of the world is inherently more complex for five reasons. First, different countries have different home-country advantages in different industries; competing effectively requires an understanding of these differences. Second, there are location-based advantages to conducting par- ticular value chain activities in different parts of the world. Third, different political and economic conditions make the general business climate more favorable in some countries than in others. Fourth, companies face risk due to adverse shifts in currency exchange rates when operating in foreign markets. And fifth, differences in buyer tastes and preferences present a challenge for companies concerning customizing ver- sus standardizing their products and services.
Home-Country Industry Advantages and the Diamond Model Certain countries are known for their strengths in particular industries. For example, Chile has competitive strengths in industries such as copper, fruit, fish products, paper and pulp, chemicals, and wine. Japan is known for competitive strength in con- sumer electronics, automobiles, semiconductors, steel products, and specialty steel. Where industries are more likely to develop competitive strength depends on a set of factors that describe the nature of each country’s business environment and vary from country to country. Because strong industries are made up of strong firms, the strategies of firms that expand internationally are usually grounded in one or more of these factors. The four major factors are summarized in a framework developed by Michael Porter and known as the Diamond of National Competitive Advantage (see Figure 7.1).3
Demand Conditions The demand conditions in an industry’s home market include the relative size of the market, its growth potential, and the nature of domestic buyers’ needs and wants. Differing population sizes, income levels, and other demo- graphic factors give rise to considerable differences in market size and growth rates from country to country. Industry sectors that are larger and more important in their home market tend to attract more resources and grow faster than others. For exam- ple, owing to widely differing population demographics and income levels, there is a far bigger market for luxury automobiles in the United States and Germany than in Argentina, India, Mexico, and China. At the same time, in developing markets like India, China, Brazil, and Malaysia, market growth potential is far higher than it is in the more mature economies of Britain, Denmark, Canada, and Japan. The potential for market growth in automobiles is explosive in China, where 2015 sales of new vehicles amounted to 26.4 million, surpassing U.S. sales of 17.2 million and making China the world’s largest market for the sixth year in a row.4 Demanding domestic buyers for an industry’s products spur greater innovativeness and improvements in quality. Such conditions foster the development of stronger industries, with firms that are capable of translating a home-market advantage into a competitive advantage in the international arena.
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Factor Conditions Factor conditions describe the availability, quality, and cost of raw materials and other inputs (called factors of production) that firms in an industry require for producing their products and services. The relevant factors of production vary from industry to industry but can include different types of labor, technical or manage- rial knowledge, land, financial capital, and natural resources. Elements of a country’s infrastructure may be included as well, such as its transportation, communication, and banking systems. For instance, in India there are efficient, well-developed national chan- nels for distributing groceries, personal care items, and other packaged products to the country’s 3 million retailers, whereas in China distribution is primarily local and there is a limited national network for distributing most products. Competitively strong indus- tries and firms develop where relevant factor conditions are favorable.
FIGURE 7.1 The Diamond of National Competitive Advantage
Firm Strategy, Structure, and Rivalry:
Di�erent styles of management and organization; degree of local rivalry
Factor Conditions:
Availability and relative prices of inputs (e.g., labor, materials)
Related and Supporting Industries:
Proximity of suppliers, end users, and complementary industries
HOME-COUNTRY ADVANTAGE
Home-market size and growth rate; buyers’ tastes
Demand Conditions:
Source: Adapted from Michael E. Porter, “The Competitive Advantage of Nations,” Harvard Business Review, March–April 1990, pp. 73–93.
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Related and Supporting Industries Robust industries often develop in locales where there is a cluster of related industries, including others within the same value chain system (e.g., suppliers of components and equipment, distributors) and the makers of complementary products or those that are technologically related. The sports car makers Ferrari and Maserati, for example, are located in an area of Italy known as the “engine technological district,” which includes other firms involved in racing, such as Ducati Motorcycles, along with hundreds of small suppliers. The advantage to firms that develop as part of a related-industry cluster comes from the close collaboration with key suppliers and the greater knowledge sharing throughout the cluster, resulting in greater efficiency and innovativeness.
Firm Strategy, Structure, and Rivalry Different country environ- ments foster the development of different styles of management, organization, and strategy. For example, strategic alliances are a more common strategy for firms from Asian or Latin American countries, which emphasize trust and cooperation in their organizations, than for firms from North America, where individualism is more influ- ential. In addition, countries vary in terms of the competitive rivalry of their industries. Fierce rivalry in home markets tends to hone domestic firms’ competitive capabilities and ready them for competing internationally.
For an industry in a particular country to become competitively strong, all four factors must be favorable for that industry. When they are, the industry is likely to con- tain firms that are capable of competing successfully in the international arena. Thus the diamond framework can be used to reveal the answers to several questions that are important for competing on an international basis. First, it can help predict where for- eign entrants into an industry are most likely to come from. This can help managers prepare to cope with new foreign competitors, since the framework also reveals some- thing about the basis of the new rivals’ strengths. Second, it can reveal the countries in which foreign rivals are likely to be weakest and thus can help managers decide which foreign markets to enter first. And third, because it focuses on the attributes of a country’s business environment that allow firms to flourish, it reveals something about the advantages of conducting particular business activities in that country. Thus the diamond framework is an aid to deciding where to locate different value chain activities most beneficially—a topic that we address next.
Opportunities for Location-Based Advantages Increasingly, companies are locating different value chain activities in different parts of the world to exploit location-based advantages that vary from country to country. This is particularly evident with respect to the location of manufacturing activities. Differences in wage rates, worker productivity, energy costs, and the like create siz- able variations in manufacturing costs from country to country. By locating its plants in certain countries, firms in some industries can reap major manufacturing cost advantages because of lower input costs (especially labor), relaxed government regu- lations, the proximity of suppliers and technologically related industries, or unique natural resources. In such cases, the low-cost countries become principal production sites, with most of the output being exported to markets in other parts of the world. Companies that build production facilities in low-cost countries (or that source their products from contract manufacturers in these countries) gain a competitive advan- tage over rivals with plants in countries where costs are higher. The competitive role of low manufacturing costs is most evident in low-wage countries like China, India,
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Pakistan, Cambodia, Vietnam, Mexico, Brazil, Guatemala, the Philippines, and sev- eral countries in Africa and eastern Europe that have become production havens for manufactured goods with high labor content (especially textiles and apparel). Hourly compensation for manufacturing workers in 2013 averaged about $1.46 in India, $2.12 in the Philippines, $3.07 in China, $6.82 in Mexico, $9.37 in Taiwan, $9.44 in Hungary, $10.69 in Brazil, $12.90 in Portugal, $21.96 in South Korea, $25.85 in New Zealand, $29.13 in Japan, $36.33 in Canada, $36.34 in the United States, $48.98 in Germany, and $65.86 in Norway.5 China emerged as the manufacturing capital of the world in large part because of its low wages—virtually all of the world’s major manufactur- ing companies now have facilities in China. This in turn has driven up their wages to nearly double the average wage offered in 2012.
For other types of value chain activities, input quality or availability are more important considerations. Tiffany & Co. entered the mining industry in Canada to access diamonds that could be certified as “conflict free” and not associated with either the funding of African wars or unethical mining conditions. Many U.S. com- panies locate call centers in countries such as India and Ireland, where English is spoken and the workforce is well educated. Other companies locate R&D activities in countries where there are prestigious research institutions and well-trained scientists and engineers. Likewise, concerns about short delivery times and low shipping costs make some countries better locations than others for establishing distribution centers.
The Impact of Government Policies and Economic Conditions in Host Countries Cross-country variations in government policies and economic conditions affect both the opportunities available to a foreign entrant and the risks of operating within the host country. The governments of some countries are eager to attract foreign invest- ments, and thus they go all out to create a business climate that outsiders will view as favorable. Governments eager to spur economic growth, create more jobs, and raise living standards for their citizens usually enact policies aimed at stimulating busi- ness innovation and capital investment; Ireland is a good example. They may provide such incentives as reduced taxes, low-cost loans, site location and site development assistance, and government-sponsored training for workers to encourage companies to construct production and distribution facilities. When new business-related issues or developments arise, “pro-business” governments make a practice of seeking advice and counsel from business leaders. When tougher business-related regulations are deemed appropriate, they endeavor to make the transition to more costly and stringent regulations somewhat business-friendly rather than adversarial.
On the other hand, governments sometimes enact policies that, from a business perspective, make locating facilities within a country’s borders less attractive. For example, the nature of a company’s operations may make it particularly costly to achieve compliance with a country’s environmental regulations. Some governments provide subsidies and low-interest loans to domestic companies to enable them to bet- ter compete against foreign companies. To discourage foreign imports, governments may enact deliberately burdensome procedures and requirements regarding customs inspection for foreign goods and may impose tariffs or quotas on imports. Addition- ally, they may specify that a certain percentage of the parts and components used in manufacturing a product be obtained from local suppliers, require prior approval of capital spending projects, limit withdrawal of funds from the country, and require par- tial ownership of foreign company operations by local companies or investors. There
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are times when a government may place restrictions on exports to ensure adequate local supplies and regulate the prices of imported and locally produced goods. Such government actions make a country’s business climate less attractive and in some cases may be sufficiently onerous as to discourage a company from locating facilities in that country or even selling its products there.
A country’s business climate is also a function of the political and economic risks associated with operating within its borders. Political risks have to do with the instability of weak governments, growing possibilities that a country’s citizenry will revolt against dictatorial government leaders, the likelihood of new onerous legislation or regulations on foreign-owned businesses, and the potential for future elections to produce corrupt or tyrannical government leaders. In industries that a government deems critical to the national welfare, there is sometimes a risk that the government will nationalize the industry and expropriate the assets of foreign com- panies. In 2012, for example, Argentina nationalized the country’s top oil producer, YPF, which was owned by Spanish oil major Repsol. Other political risks include the loss of investments due to war or political unrest, regulatory changes that create operating uncertainties, security risks due to terrorism, and corruption. Economic risks have to do with instability of a country’s economy and monetary system— whether inflation rates might skyrocket or whether uncontrolled deficit spending on the part of government or risky bank lending practices could lead to a breakdown of the country’s monetary system and prolonged economic distress. In some countries, the threat of piracy and lack of protection for intellectual property are also sources of economic risk. Another is fluctuations in the value of different currencies—a factor that we discuss in more detail next.
The Risks of Adverse Exchange Rate Shifts When companies produce and market their products and services in many different countries, they are subject to the impacts of sometimes favorable and sometimes unfa- vorable changes in currency exchange rates. The rates of exchange between different currencies can vary by as much as 20 to 40 percent annually, with the changes occur- ring sometimes gradually and sometimes swiftly. Sizable shifts in exchange rates pose significant risks for two reasons:
1. They are hard to predict because of the variety of factors involved and the uncer- tainties surrounding when and by how much these factors will change.
2. They create uncertainty regarding which countries represent the low-cost manu- facturing locations and which rivals have the upper hand in the marketplace.
To illustrate the economic and competitive risks associated with fluctuating exchange rates, consider the case of a U.S. company that has located manufactur- ing facilities in Brazil (where the currency is reals—pronounced “ray-alls”) and that exports most of the Brazilian-made goods to markets in the European Union (where the currency is euros). To keep the numbers simple, assume that the exchange rate is 4 Brazilian reals for 1 euro and that the product being made in Brazil has a manufactur- ing cost of 4 Brazilian reals (or 1 euro). Now suppose that the exchange rate shifts from 4 reals per euro to 5 reals per euro (meaning that the real has declined in value and that the euro is stronger). Making the product in Brazil is now more cost-competitive because a Brazilian good costing 4 reals to produce has fallen to only 0.8 euro at the new exchange rate (4 reals divided by 5 reals per euro = 0.8 euro). This clearly puts the producer of the Brazilian-made good in a better position to compete against
CORE CONCEPT
Political risks stem from instability or weakness in national governments and hostility to foreign business. Economic risks stem from instability in a country’s monetary system, economic and regulatory policies, and the lack of property rights protections.
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the European makers of the same good. On the other hand, should the value of the Brazilian real grow stronger in relation to the euro—resulting in an exchange rate of 3 reals to 1 euro—the same Brazilian-made good formerly costing 4 reals (or 1 euro) to produce now has a cost of 1.33 euros (4 reals divided by 3 reals per euro = 1.33 euros), putting the producer of the Brazilian-made good in a weaker competitive position vis- à-vis the European producers. Plainly, the attraction of manufacturing a good in Brazil and selling it in Europe is far greater when the euro is strong (an exchange rate of 1 euro for 5 Brazilian reals) than when the euro is weak and exchanges for only 3 Brazil- ian reals.
But there is one more piece to the story. When the exchange rate changes from 4 reals per euro to 5 reals per euro, not only is the cost-competitiveness of the Brazilian manufacturer stronger relative to European manufacturers of the same item but the Brazilian-made good that formerly cost 1 euro and now costs only 0.8 euro can also be sold to consumers in the European Union for a lower euro price than before. In other words, the combination of a stronger euro and a weaker real acts to lower the price of Brazilian-made goods in all the countries that are members of the European Union, which is likely to spur sales of the Brazilian-made good in Europe and boost Brazilian exports to Europe. Conversely, should the exchange rate shift from 4 reals per euro to 3 reals per euro—which makes the Brazilian manufacturer less cost- competitive with European manufacturers of the same item—the Brazilian-made good that formerly cost 1 euro and now costs 1.33 euros will sell for a higher price in euros than before, thus weakening the demand of European consumers for Brazilian-made goods and acting to reduce Brazilian exports to Europe. Brazilian exporters are likely to experi- ence (1) rising demand for their goods in Europe whenever the Brazilian real grows weaker relative to the euro and (2) falling demand for their goods in Europe whenever the real grows stronger relative to the euro. Consequently, from the standpoint of a company with Brazilian manufacturing plants, a weaker Brazilian real is a favor- able exchange rate shift and a stronger Brazilian real is an unfavorable exchange rate shift.
It follows from the previous discussion that shifting exchange rates have a big impact on the ability of domestic manufacturers to compete with foreign rivals. For example, U.S.-based manufacturers locked in a fierce competitive battle with low-cost foreign imports benefit from a weaker U.S. dollar. There are several reasons why this is so:
∙ Declines in the value of the U.S. dollar against foreign currencies raise the U.S. dollar costs of goods manufactured by foreign rivals at plants located in the coun- tries whose currencies have grown stronger relative to the U.S. dollar. A weaker dollar acts to reduce or eliminate whatever cost advantage foreign manufacturers may have had over U.S. manufacturers (and helps protect the manufacturing jobs of U.S. workers).
∙ A weaker dollar makes foreign-made goods more expensive in dollar terms to U.S. consumers—this curtails U.S. buyer demand for foreign-made goods, stimu- lates greater demand on the part of U.S. consumers for U.S.-made goods, and reduces U.S. imports of foreign-made goods.
∙ A weaker U.S. dollar enables the U.S.-made goods to be sold at lower prices to consumers in countries whose currencies have grown stronger relative to the U.S. dollar—such lower prices boost foreign buyer demand for the now relatively cheaper U.S.-made goods, thereby stimulating exports of U.S.-made goods to foreign countries and creating more jobs in U.S.-based manufacturing plants.
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∙ A weaker dollar has the effect of increasing the dollar value of profits a com- pany earns in foreign-country markets where the local currency is stronger relative to the dollar. For example, if a U.S.-based manufacturer earns a profit of €10 million on its sales in Europe, those €10 million convert to a larger number of dollars when the dollar grows weaker against the euro.
A weaker U.S. dollar is therefore an economically favorable exchange rate shift for manufacturing plants based in the United States. A decline in the value of the U.S. dollar strengthens the cost-competitiveness of U.S.-based manufacturing plants and boosts buyer demand for U.S.-made goods. When the value of the U.S. dollar is expected to remain weak for some time to come, foreign companies have an incentive to build manufacturing facilities in the United States to make goods for U.S. consumers rather than export the same goods to the United States from foreign plants where production costs in dollar terms have been driven up by the decline in the value of the dollar. Conversely, a stronger U.S. dollar is an unfavor- able exchange rate shift for U.S.-based manufacturing plants because it makes such plants less cost-competitive with foreign plants and weakens foreign demand for U.S.-made goods. A strong dollar also weakens the incentive of foreign companies to locate manufacturing facilities in the United States to make goods for U.S. con- sumers. The same reasoning applies to companies that have plants in countries in the European Union where euros are the local currency. A weak euro versus other currencies enhances the cost-competitiveness of companies manufacturing goods in Europe vis-à-vis foreign rivals with plants in countries whose currencies have grown stronger relative to the euro; a strong euro versus other currencies weakens the cost-competitiveness of companies with plants in the European Union.
Cross-Country Differences in Demographic, Cultural, and Market Conditions Buyer tastes for a particular product or service sometimes differ substantially from country to country. In France, consumers prefer top-loading washing machines, whereas in most other European countries consumers prefer front-loading machines. People in Hong Kong prefer compact appliances, but in Taiwan large appliances are more popular. Novelty ice cream flavors like eel, shark fin, and dried shrimp have more appeal to East Asian customers than they have for customers in the United States and in Europe. Sometimes, product designs suitable in one country are inappropriate in another because of differing local standards—for example, in the United States electrical devices run on 110-volt electric systems, but in some European countries the standard is a 240-volt electric system, necessitating the use of different electrical designs and components. Cultural influences can also affect consumer demand for a product. For instance, in South Korea many parents are reluctant to purchase PCs even when they can afford them because of concerns that their children will be dis- tracted from their schoolwork by surfing the Web, playing PC-based video games, and becoming Internet “addicts.”6
Consequently, companies operating in an international marketplace have to wres- tle with whether and how much to customize their offerings in each country mar- ket to match local buyers’ tastes and preferences or whether to pursue a strategy of offering a mostly standardized product worldwide. While making products that are closely matched to local tastes makes them more appealing to local buyers, custom- izing a company’s products country by country may raise production and distribution
Fluctuating exchange rates pose significant economic risks to a company’s competitiveness in foreign markets. Exporters are disadvantaged when the currency of the country where goods are being manufactured grows stronger relative to the currency of the importing country.
Domestic companies facing competitive pressure from lower-cost imports benefit when their government’s currency grows weaker in relation to the currencies of the countries where the lower-cost imports are being made.
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costs due to the greater variety of designs and components, shorter production runs, and the complications of added inventory handling and distribution logistics. Greater standardization of a global company’s product offering, on the other hand, can lead to scale economies and learning-curve effects, thus reducing per-unit production costs and contributing to the achievement of a low-cost advantage. The tension between the market pressures to localize a company’s product offerings country by country and the competitive pressures to lower costs is one of the big strategic issues that partici- pants in foreign markets have to resolve.
LO 3
The five major strategic options for entering foreign markets.
STRATEGIC OPTIONS FOR ENTERING INTERNATIONAL MARKETS
Once a company decides to expand beyond its domestic borders, it must consider the question of how to enter foreign markets. There are five primary strategic options for doing so:
1. Maintain a home-country production base and export goods to foreign markets. 2. License foreign firms to produce and distribute the company’s products abroad. 3. Employ a franchising strategy in foreign markets. 4. Establish a subsidiary in a foreign market via acquisition or internal development. 5. Rely on strategic alliances or joint ventures with foreign companies.
Which option to employ depends on a variety of factors, including the nature of the firm’s strategic objectives, the firm’s position in terms of whether it has the full range of resources and capabilities needed to operate abroad, country-specific factors such as trade barriers, and the transaction costs involved (the costs of contracting with a partner and monitoring its compliance with the terms of the contract, for example). The options vary considerably regarding the level of investment required and the asso- ciated risks—but higher levels of investment and risk generally provide the firm with the benefits of greater ownership and control.
Export Strategies Using domestic plants as a production base for exporting goods to foreign markets is an excellent initial strategy for pursuing international sales. It is a conservative way to test the international waters. The amount of capital needed to begin exporting is often minimal; existing production capacity may well be sufficient to make goods for export. With an export-based entry strategy, a manufacturer can limit its involvement in foreign markets by contracting with foreign wholesalers experienced in importing to handle the entire distribution and marketing function in their countries or regions of the world. If it is more advantageous to maintain control over these functions, how- ever, a manufacturer can establish its own distribution and sales organizations in some or all of the target foreign markets. Either way, a home-based production and export strategy helps the firm minimize its direct investments in foreign countries. Such strat- egies are commonly favored by Chinese, Korean, and Italian companies—products are designed and manufactured at home and then distributed through local channels in the importing countries. The primary functions performed abroad relate chiefly to
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establishing a network of distributors and perhaps conducting sales promotion and brand-awareness activities.
Whether an export strategy can be pursued successfully over the long run depends on the relative cost-competitiveness of the home-country production base. In some industries, firms gain additional scale economies and learning-curve benefits from centralizing production in plants whose output capability exceeds demand in any one country market; exporting enables a firm to capture such economies. However, an export strategy is vulnerable when (1) manufacturing costs in the home country are substantially higher than in foreign countries where rivals have plants, (2) the costs of shipping the product to distant foreign markets are relatively high, (3) adverse shifts occur in currency exchange rates, and (4) importing countries impose tariffs or erect other trade barriers. Unless an exporter can keep its production and shipping costs competitive with rivals’ costs, secure adequate local distribution and marketing sup- port of its products, and effectively hedge against unfavorable changes in currency exchange rates, its success will be limited.
Licensing Strategies Licensing as an entry strategy makes sense when a firm with valuable technical know- how, an appealing brand, or a unique patented product has neither the internal organi- zational capability nor the resources to enter foreign markets. Licensing also has the advantage of avoiding the risks of committing resources to country markets that are unfamiliar, politically volatile, economically unstable, or otherwise risky. By licens- ing the technology, trademark, or production rights to foreign-based firms, a company can generate income from royalties while shifting the costs and risks of entering for- eign markets to the licensee. The big disadvantage of licensing is the risk of provid- ing valuable technological know-how to foreign companies and thereby losing some degree of control over its use; monitoring licensees and safeguarding the company’s proprietary know-how can prove quite difficult in some circumstances. But if the royalty potential is considerable and the companies to which the licenses are being granted are trustworthy and reputable, then licensing can be a very attractive option. Many software and pharmaceutical companies use licensing strategies to participate in foreign markets.
Franchising Strategies While licensing works well for manufacturers and owners of proprietary technology, franchising is often better suited to the international expansion efforts of service and retailing enterprises. McDonald’s, Yum! Brands (the parent of Pizza Hut, KFC, Taco Bell, and WingStreet), the UPS Store, Roto-Rooter, 7-Eleven, and Hilton Hotels have all used franchising to build a presence in foreign markets. Franchising has many of the same advantages as licensing. The franchisee bears most of the costs and risks of establishing foreign locations; a franchisor has to expend only the resources to recruit, train, support, and monitor franchisees. The problem a franchisor faces is maintain- ing quality control; foreign franchisees do not always exhibit strong commitment to consistency and standardization, especially when the local culture does not stress the same kinds of quality concerns. A question that can arise is whether to allow foreign franchisees to make modifications in the franchisor’s product offering so as to better satisfy the tastes and expectations of local buyers. Should McDonald’s give franchisees in each nation some leeway in what products they put on their menus?
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Should franchised KFC units in China be permitted to substitute spices that appeal to Chinese consumers? Or should the same menu offerings be rigorously and unvary- ingly required of all franchisees worldwide?
Foreign Subsidiary Strategies Very often companies electing to compete internationally or globally prefer to have direct control over all aspects of operating in a foreign market. Companies that want to direct performance of all essential value chain activities typically establish a wholly owned subsidiary, either by acquiring a local company or by establishing its own new operating organization from the ground up. A subsidiary business that is established internally from scratch is called an internal startup or a greenfield venture.
Acquiring a local business is the quicker of the two options; it may be the least risky and most cost-efficient means of hurdling such entry barriers as gaining
access to local distribution channels, building supplier relationships, and establish- ing working relationships with government officials and other key constituencies. Buying an ongoing operation allows the acquirer to move directly to the task of transferring resources and personnel to the newly acquired business, redirecting and integrating the activities of the acquired business into its own operation, put- ting its own strategy into place, and accelerating efforts to build a strong market position.
One thing an acquisition-minded firm must consider is whether to pay a premium price for a successful local company or to buy a struggling competitor at a bargain price. If the buying firm has little knowledge of the local market but ample capital, it is often better off purchasing a capable, strongly positioned firm. However, when the acquirer sees promising ways to transform a weak firm into a strong one and has the resources and managerial know-how to do so, a struggling company can be the better long-term investment.
Entering a new foreign country via a greenfield venture makes sense when a company already operates in a number of countries, has experience in establishing new subsidiaries and overseeing their operations, and has a sufficiently large pool of resources and capabilities to rapidly equip a new subsidiary with the personnel and competencies it needs to compete successfully and profitably. Four other conditions make a greenfield venture strategy appealing:
∙ When creating an internal startup is cheaper than making an acquisition. ∙ When adding new production capacity will not adversely impact the supply–
demand balance in the local market. ∙ When a startup subsidiary has the ability to gain good distribution access (perhaps
because of the company’s recognized brand name). ∙ When a startup subsidiary will have the size, cost structure, and capabilities to
compete head-to-head against local rivals.
Greenfield ventures in foreign markets can also pose problems, just as other entry strategies do. They represent a costly capital investment, subject to a high level of risk. They require numerous other company resources as well, diverting them from other uses. They do not work well in countries without strong, well-functioning markets and institutions that protect the rights of foreign investors and provide other legal protec- tions. Moreover, an important disadvantage of greenfield ventures relative to other means of international expansion is that they are the slowest entry route—particularly
CORE CONCEPT
A greenfield venture (or internal startup) is a subsidiary business that is established by setting up the entire operation from the ground up.
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if the objective is to achieve a sizable market share. On the other hand, successful greenfield ventures may offer higher returns to compensate for their high risk and slower path.
Alliance and Joint Venture Strategies Strategic alliances, joint ventures, and other cooperative agreements with foreign companies are a widely used means of entering foreign markets.7 A company can benefit immensely from a foreign partner’s familiarity with local government reg- ulations, its knowledge of the buying habits and product preferences of consumers, its distribution-channel relationships, and so on.8 Both Japanese and American companies are actively forming alliances with European companies to better compete in the 27-nation European Union (and the five countries that are candidates to become EU members). Many U.S. and European companies are allying with Asian companies in their efforts to enter markets in China, India, Thailand, Indonesia, and other Asian countries.
Another reason for cross-border alliances is to capture economies of scale in production and/or marketing. By joining forces in producing components, assem- bling models, and marketing their products, companies can realize cost savings not achievable with their own small volumes. A third reason to employ a collaborative strategy is to share distribution facilities and dealer networks, thus mutually strength- ening each partner’s access to buyers. A fourth benefit of a collaborative strategy is the learning and added expertise that comes from performing joint research, shar- ing technological know-how, studying one another’s manufacturing methods, and understanding how to tailor sales and marketing approaches to fit local cultures and traditions. A fifth benefit is that cross-border allies can direct their competi- tive energies more toward mutual rivals and less toward one another; teaming up may help them close the gap on leading companies. And, finally, alliances can be a particularly useful way for companies across the world to gain agreement on impor- tant technical standards—they have been used to arrive at standards for assorted PC devices, Internet-related technologies, high-definition televisions, and mobile phones.
Cross-border alliances are an attractive means of gaining the aforementioned types of benefits (as compared to merging with or acquiring foreign-based companies) because they allow a company to preserve its independence (which is not the case with a merger) and avoid using scarce financial resources to fund acquisitions. Further- more, an alliance offers the flexibility to readily disengage once its purpose has been served or if the benefits prove elusive, whereas mergers and acquisitions are more permanent arrangements.9
Alliances may also be used to pave the way for an intended merger; they offer a way to test the value and viability of a cooperative arrangement with a foreign partner before making a more permanent commitment. Illustration Capsule 7.1 shows how Walgreens pursued this strategy with Alliance Boots in order to facilitate its expan- sion abroad.
The Risks of Strategic Alliances with Foreign Partners Alli- ances and joint ventures with foreign partners have their pitfalls, however. Sometimes a local partner’s knowledge and expertise turns out to be less valuable than expected (because its knowledge is rendered obsolete by fast-changing market conditions or because its operating practices are archaic). Cross-border allies typically must over- come language and cultural barriers and figure out how to deal with diverse (or con- flicting) operating practices. The transaction costs of working out a mutually agreeable
Collaborative strategies involving alliances or joint ventures with foreign partners are a popular way for companies to edge their way into the markets of foreign countries.
Cross-border alliances enable a growth-minded company to widen its geographic coverage and strengthen its competitiveness in foreign markets; at the same time, they offer flexibility and allow a company to retain some degree of autonomy and operating control.
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arrangement and monitoring partner compliance with the terms of the arrangement can be high. The communication, trust building, and coordination costs are not trivial in terms of management time.10 Often, partners soon discover they have conflicting objectives and strategies, deep differences of opinion about how to proceed, or impor- tant differences in corporate values and ethical standards. Tensions build, working
Walgreens pharmacy began in 1901 as a single store on the South Side of Chicago, and grew to become the larg- est chain of pharmacy retailers in America. Walgreens was an early pioneer of the “self-service” pharmacy and found success by moving quickly to build a vast domes- tic network of stores after the Second World War. This growth-focused strategy served Walgreens well up until the beginning of the 21st century, by which time it had nearly saturated the U.S. market. By 2014, 75 percent of Americans lived within five miles of a Walgreens. The company was also facing threats to its core busi- ness model. Walgreens relies heavily on pharmacy sales, which generally are paid for by someone other than the patient, usually the government or an insurance com- pany. As the government and insurers started to make a more sustained effort to cut costs, Walgreens’s core profit center was at risk. To mitigate these threats, Wal- greens looked to enter foreign markets.
Walgreens found an ideal international partner in Alliance Boots. Based in the UK, Alliance Boots had a global footprint with 3,300 stores across 10 countries. A partnership with Alliance Boots had several strategic advantages, allowing Walgreens to gain swift entry into foreign markets as well as complementary assets and expertise. First, it gave Walgreens access to new mar- kets beyond the saturated United States for its retail pharmacies. Second, it provided Walgreens with a new revenue stream in wholesale drugs. Alliance Boots held a vast European distribution network for wholesale drug sales; Walgreens could leverage that network and expertise to build a similar model in the United States. Finally, a merger with Alliance Boots would strengthen Walgreens’s existing business by increasing the com- pany’s market position and therefore bargaining power
with drug companies. In light of these advantages, Walgreens moved quickly to partner with and later acquire Alliance Boots and merged both companies in 2014 to become Walgreens Boots Alliance. Walgreens Boots Alliance, Inc. is now one of the world’s largest drug purchasers, able to negotiate from a strong posi- tion with drug companies and other suppliers to realize economies of scale in its current businesses.
The market has thus far responded favorably to the merger. Walgreens Boots Alliance’s stock has more than doubled in value since the first news of the part- nership in 2012. However, the company is still struggling to integrate and faces new risks such as currency fluc- tuation in its new combined position. Yet as the pharma- ceutical industry continues to consolidate, Walgreens is in an undoubtedly stronger position to continue to grow in the future thanks to its strategic international acquisition.
© Michael Nagle/Bloomberg via Getty Images
Note: Developed with Katherine Coster.
Sources: Company 10-K Form, 2015, investor.walgreensbootsalliance.com/secfiling.cfm?filingID=1140361-15-38791&CIK=1618921; L. Capron and W. Mitchell, “When to Change a Winning Strategy,” Harvard Business Review, July 25, 2012, hbr.org/2012/07/when-to-change-a- winning-strat; T. Martin and R. Dezember, “Walgreen Spends $6.7 Billion on Alliance Boots Stake,” The Wall Street Journal, June 20, 2012.
ILLUSTRATION CAPSULE 7.1
Walgreens Boots Alliance, Inc.: Entering Foreign Markets via Alliance Followed by Merger
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relationships cool, and the hoped-for benefits never materialize.11 It is not unusual for there to be little personal chemistry among some of the key people on whom the suc- cess or failure of the alliance depends—the rapport such personnel need to work well together may never emerge. And even if allies are able to develop productive personal relationships, they can still have trouble reaching mutually agreeable ways to deal with key issues or launching new initiatives fast enough to stay abreast of rapid advances in technology or shifting market conditions.
One worrisome problem with alliances or joint ventures is that a firm may risk los- ing some of its competitive advantage if an alliance partner is given full access to its proprietary technological expertise or other competitively valuable capabilities. There is a natural tendency for allies to struggle to collaborate effectively in competitively sensitive areas, thus spawning suspicions on both sides about forthright exchanges of information and expertise. It requires many meetings of many people working in good faith over a period of time to iron out what is to be shared, what is to remain propri- etary, and how the cooperative arrangements will work.
Even if the alliance proves to be a win–win proposition for both parties, there is the danger of becoming overly dependent on foreign partners for essential expertise and competitive capabilities. Companies aiming for global market leadership need to develop their own resource capabilities in order to be masters of their destiny. Fre- quently, experienced international companies operating in 50 or more countries across the world find less need for entering into cross-border alliances than do companies in the early stages of globalizing their operations.12 Companies with global opera- tions make it a point to develop senior managers who understand how “the system” works in different countries, plus they can avail themselves of local managerial talent and know-how by simply hiring experienced local managers and thereby detouring the hazards of collaborative alliances with local companies. One of the lessons about cross-border partnerships is that they are more effective in helping a company estab- lish a beachhead of new opportunity in world markets than they are in enabling a company to achieve and sustain global market leadership.
LO 4
The three main strategic approaches for competing internationally.
CORE CONCEPT
An international strategy is a strategy for competing in two or more countries simultaneously.
INTERNATIONAL STRATEGY: THE THREE MAIN APPROACHES Broadly speaking, a firm’s international strategy is simply its strategy for competing in two or more countries simultaneously. Typically, a company will start to compete internationally by entering one or perhaps a select few foreign markets—selling its products or services in countries where there is a ready market for them. But as it expands further internationally, it will have to confront head-on two conflicting pres- sures: the demand for responsiveness to local needs versus the prospect of efficiency gains from offering a standardized product globally. Deciding on the degree to vary its competitive approach to fit the specific market conditions and buyer preferences in each host country is perhaps the foremost strategic issue that must be addressed when a company is operating in two or more foreign markets.13 Figure 7.2 shows a company’s three options for resolving this issue: choosing a multidomestic, global, or transnational strategy.
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Multidomestic Strategies—a “Think-Local, Act-Local” Approach
A multidomestic strategy is one in which a company varies its product offering and competitive approach from country to country in an effort to meet differing buyer needs and to address divergent local-market conditions. It involves having plants produce dif- ferent product versions for different local markets and adapting marketing and distri- bution to fit local customs, cultures, regulations, and market requirements. Castrol, a specialist in oil lubricants, produces over 3,000 different formulas of lubricants to meet the requirements of different climates, vehicle types and uses, and equipment applica- tions that characterize different country markets. In the food products industry, it is common for companies to vary the ingredients in their products and sell the localized versions under local brand names to cater to country-specific tastes and eating prefer- ences. Government requirements for gasoline additives that help reduce carbon monox- ide, smog, and other emissions are almost never the same from country to country. BP utilizes localized strategies in its gasoline and service station business segment because of these cross-country formulation differences and because of customer familiarity with local brand names. For example, the company markets gasoline in the United States under its BP and Arco brands, but markets gasoline in Germany, Belgium, Poland, Hungary, and the Czech Republic under the Aral brand.
CORE CONCEPT
A multidomestic strategy is one in which a company varies its product offering and competitive approach from country to country in an effort to be responsive to differing buyer preferences and market conditions. It is a think-local, act-local type of international strategy, facilitated by decision making decentralized to the local level.
FIGURE 7.2 Three Approaches for Competing Internationally
Think Global—Act Local
TRANSNATIONAL STRATEGY
Think Local—Act Local
MULTIDOMESTIC STRATEGY
Low
Need for Local Responsiveness
B e n e fit s fr o m G lo b a l I n te g ra tio
n a n d S ta n d a rd iz a tio
n
High
Low
High
GLOBAL STRATEGY
Think Global—Act Global
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In essence, a multidomestic strategy represents a think-local, act-local approach to international strategy. A think-local, act-local approach to strategy making is most appropriate when the need for local responsiveness is high due to significant cross- country differences in demographic, cultural, and market conditions and when the potential for efficiency gains from standardization is limited, as depicted in Figure 7.2. A think-local, act-local approach is possible only when decision making is decentral- ized, giving local managers considerable latitude for crafting and executing strategies for the country markets they are responsible for. Giving local managers decision- making authority allows them to address specific market needs and respond swiftly to local changes in demand. It also enables them to focus their competitive efforts, stake out attractive market positions vis-à-vis local competitors, react to rivals’ moves in a timely fashion, and target new opportunities as they emerge.14
Despite their obvious benefits, think-local, act-local strategies have three big drawbacks:
1. They hinder transfer of a company’s capabilities, knowledge, and other resources across country boundaries, since the company’s efforts are not integrated or coordi- nated across country boundaries. This can make the company less innovative overall.
2. They raise production and distribution costs due to the greater variety of designs and components, shorter production runs for each product version, and complica- tions of added inventory handling and distribution logistics.
3. They are not conducive to building a single, worldwide competitive advantage. When a company’s competitive approach and product offering vary from country to country, the nature and size of any resulting competitive edge also tends to vary. At the most, multidomestic strategies are capable of producing a group of local competitive advantages of varying types and degrees of strength.
Global Strategies—a “Think-Global, Act-Global” Approach A global strategy contrasts sharply with a multidomestic strategy in that it takes a standardized, globally integrated approach to producing, packaging, selling, and delivering the company’s products and services worldwide. Companies employing a global strategy sell the same products under the same brand names everywhere, uti- lize much the same distribution channels in all countries, and compete on the basis of the same capabilities and marketing approaches worldwide. Although the com- pany’s strategy or product offering may be adapted in minor ways to accommodate specific situations in a few host countries, the company’s fundamental competitive approach (low cost, differentiation, best cost, or focused) remains very much intact worldwide and local managers stick close to the global strategy.
A think-global, act-global approach prompts company managers to integrate and coordinate the company’s strategic moves worldwide and to expand into most, if not all, nations where there is significant buyer demand. It puts considerable strategic emphasis on building a global brand name and aggressively pursuing opportunities to transfer ideas, new products, and capabilities from one country to another. Global strategies are characterized by relatively centralized value chain activities, such as production and distribution. While there may be more than one manufacturing plant and distribution center to minimize transportation costs, for example, they tend to be few in number. Achieving the efficiency potential of a global strategy requires that resources and best practices be shared, value chain
CORE CONCEPT
A global strategy is one in which a company employs the same basic competitive approach in all countries where it operates, sells standardized products globally, strives to build global brands, and coordinates its actions worldwide with strong headquarters control. It represents a think-global, act-global approach.
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activities be integrated, and capabilities be transferred from one location to another as they are developed. These objectives are best facilitated through centralized decision making and strong headquarters control.
Because a global strategy cannot accommodate varying local needs, it is an appro- priate strategic choice when there are pronounced efficiency benefits from standard- ization and when buyer needs are relatively homogeneous across countries and regions. A globally standardized and integrated approach is especially beneficial when high volumes significantly lower costs due to economies of scale or added experience (mov- ing the company further down a learning curve). It can also be advantageous if it allows the firm to replicate a successful business model on a global basis efficiently or engage in higher levels of R&D by spreading the fixed costs and risks over a higher-volume output. It is a fitting response to industry conditions marked by global competition.
Ford’s global design strategy is a move toward a think-global, act-global strat- egy, involving the development and production of standardized models with country- specific modifications limited to what is required to meet local country emission and safety standards. The 2010 Ford Fiesta and 2011 Ford Focus were the company’s first global design models to be marketed in Europe, North America, Asia, and Australia. Whenever country-to-country differences are small enough to be accommodated within the framework of a global strategy, a global strategy is preferable because a com- pany can more readily unify its operations and focus on establishing a brand image and reputation that are uniform from country to country. Moreover, with a global strategy a company is better able to focus its full resources on securing a sustainable low-cost or differentiation-based competitive advantage over both domestic rivals and global rivals.
There are, however, several drawbacks to global strategies: (1) They do not enable firms to address local needs as precisely as locally based rivals can; (2) they are less responsive to changes in local market conditions, in the form of either new opportuni- ties or competitive threats; (3) they raise transportation costs and may involve higher tariffs; and (4) they involve higher coordination costs due to the more complex task of managing a globally integrated enterprise.
Transnational Strategies—a “Think-Global, Act-Local” Approach
A transnational strategy (sometimes called glocalization) incorporates elements of both a globalized and a localized approach to strategy making. This type of middle-ground strategy is called for when there are relatively high needs for local responsiveness as well as appreciable benefits to be realized from standardiza- tion, as Figure 7.2 suggests. A transnational strategy encourages a company to use a think-global, act-local approach to balance these competing objectives.
Often, companies implement a transnational strategy with mass- customization techniques that enable them to address local preferences in an efficient, semi- standardized manner. McDonald’s, KFC, and Starbucks have discovered ways to customize their menu offerings in various countries without compromising costs,
product quality, and operating effectiveness. Unilever is responsive to local market needs regarding its consumer products, while realizing global economies of scale in certain functions. Otis Elevator found that a transnational strategy delivers better results than a global strategy when it is competing in countries like China, where local needs are highly differentiated. By switching from its customary single-brand approach to a multi- brand strategy aimed at serving different segments of the market, Otis was able to dou- ble its market share in China and increased its revenues sixfold over a nine-year period.15
CORE CONCEPT
A transnational strategy is a think-global, act-local approach that incorporates elements of both multidomestic and global strategies.
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As a rule, most companies that operate internationally endeavor to employ as global a strategy as customer needs and market conditions permit. Electronic Arts (EA) has two major design studios—one in Vancouver, British Columbia, and one in Los Angeles—and smaller design studios in locations including San Francisco, Orlando, London, and Tokyo. This dispersion of design studios helps EA design games that are specific to different cultures—for example, the London studio took the lead in designing the popular FIFA Soccer game to suit European tastes and to replicate the stadiums, signage, and team rosters; the U.S. studio took the lead in designing games involving NFL football, NBA basketball, and NASCAR racing.
A transnational strategy is far more conducive than other strategies to transferring and leveraging subsidiary skills and capabilities. But, like other approaches to compet- ing internationally, transnational strategies also have significant drawbacks: 1. They are the most difficult of all international strategies to implement due to the
added complexity of varying the elements of the strategy to situational conditions. 2. They place large demands on the organization due to the need to pursue conflict-
ing objectives simultaneously. 3. Implementing the strategy is likely to be a costly and time-consuming enterprise,
with an uncertain outcome. Illustration Capsule 7.2 explains how Four Seasons Hotels has been able to com-
pete successfully on the basis of a transnational strategy. Table 7.1 provides a summary of the pluses and minuses of the three approaches to
competing internationally.
Advantages Disadvantages
Multidomestic (think local, act local)
• Can meet the specific needs of each market more precisely
• Can respond more swiftly to localized changes in demand
• Can target reactions to the moves of local rivals
• Can respond more quickly to local opportunities and threats
• Hinders resource and capability sharing or cross-market transfers
• Has higher production and distribution costs
• Is not conducive to a worldwide competitive advantage
Global (think global, act global)
• Has lower costs due to scale and scope economies
• Can lead to greater efficiencies due to the ability to transfer best practices across markets
• Increases innovation from knowledge sharing and capability transfer
• Offers the benefit of a global brand and reputation
• Cannot address local needs precisely
• Is less responsive to changes in local market conditions
• Involves higher transportation costs and tariffs
• Has higher coordination and integration costs
Transnational (think global, act local)
• Offers the benefits of both local responsiveness and global integration
• Enables the transfer and sharing of resources and capabilities across borders
• Provides the benefits of flexible coordination
• Is more complex and harder to implement
• Entails conflicting goals, which may be difficult to reconcile and require trade-offs
• Involves more costly and time-consuming implementation
TABLE 7.1 Advantages and Disadvantages of Multidomestic, Global, and Transnational Strategies
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Note: Developed with Brian R. McKenzie.
Sources: Four Seasons annual report and corporate website; interview with Scott Woroch, executive vice president of development, Four Seasons Hotels, February 22, 2014.
ILLUSTRATION CAPSULE 7.2
Four Seasons Hotels: Local Character, Global Service
Four Seasons Hotels is a Toronto, Canada–based man- ager of luxury hotel properties. With 98 properties located in many of the world’s most popular tourist des- tinations and business centers, Four Seasons commands a following of many of the world’s most discerning trav- elers. In contrast to its key competitor, Ritz-Carlton, which strives to create one uniform experience globally, Four Seasons Hotels has gained market share by deftly combining local architectural and cultural experiences with globally consistent luxury service.
When moving into a new market, Four Seasons always seeks out a local capital partner. The under- standing of local custom and business relationships this financier brings is critical to the process of developing a new Four Seasons hotel. Four Seasons also insists on hiring a local architect and design consultant for each property, as opposed to using architects or designers
it’s worked with in other locations. While this can be a challenge, particularly in emerging markets, Four Sea- sons has found it is worth it in the long run to have a truly local team.
The specific layout and programming of each hotel is also unique. For instance, when Four Seasons opened its hotel in Mumbai, India, it prioritized space for large banquet halls to target the Indian wedding market. In India, weddings often draw guests number- ing in the thousands. When moving into the Middle East, Four Seasons designed its hotels with separate prayer rooms for men and women. In Bali, where des- tination weddings are common, the hotel employs a “weather shaman” who, for some guests, provides reas- surance that the weather will cooperate for their spe- cial day. In all cases, the objective is to provide a truly local experience.
When staffing its hotels, Four Seasons seeks to strike a fine balance between employing locals who have an innate understanding of the local culture alongside expatriate staff or “culture carriers” who understand the DNA of Four Seasons. It also uses global systems to track customer preferences and employs globally consistent service standards. Four Seasons claims that its guests experience the same high level of service globally but that no two experi- ences are the same.
While it is much more expensive and time- consuming to design unique architectural and programming expe- riences, doing so is a strategic trade-off Four Seasons has made to achieve the local experience demanded by its high-level clientele. Likewise, it has recognized that maintaining globally consistent operation processes and service standards is important too. Four Seasons has struck the right balance between thinking globally and acting locally—the marker of a truly transnational strategy. As a result, the company has been rewarded with an international reputation for superior service and a leading market share in the luxury hospitality segment.
© Stephen Hilger/Bloomberg via Getty Images
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There are three important ways in which a firm can gain competitive advantage (or offset domestic disadvantages) by expanding outside its domestic market. First, it can use location to lower costs or achieve greater product differentiation. Second, it can transfer competi- tively valuable resources and capabilities from one country to another or share them across international borders to extend its competitive advantages. And third, it can benefit from cross-border coordination opportunities that are not open to domestic-only competitors.
Using Location to Build Competitive Advantage To use location to build competitive advantage, a company must consider two issues: (1) whether to concentrate each activity it performs in a few select countries or to disperse performance of the activity to many nations, and (2) in which coun- tries to locate particular activities.
When to Concentrate Activities in a Few Locations It is advanta- geous for a company to concentrate its activities in a limited number of locations when:
∙ The costs of manufacturing or other activities are significantly lower in some geographic locations than in others. For example, much of the world’s athletic footwear is manufactured in Asia (China and Korea) because of low labor costs; much of the production of circuit boards for PCs is located in Taiwan because of both low costs and the high-caliber technical skills of the Taiwanese labor force.
∙ Significant scale economies exist in production or distribution. The presence of sig- nificant economies of scale in components production or final assembly means that a company can gain major cost savings from operating a few super-efficient plants as opposed to a host of small plants scattered across the world. Makers of digital cam- eras and LED TVs located in Japan, South Korea, and Taiwan have used their scale economies to establish a low-cost advantage in this way. Achieving low-cost provider status often requires a company to have the largest worldwide manufacturing share (as distinct from brand share or market share), with production centralized in one or a few giant plants. Some companies even use such plants to manufacture units sold under the brand names of rivals to further boost production-related scale economies. Likewise, a company may be able to reduce its distribution costs by establishing large-scale dis- tribution centers to serve major geographic regions of the world market (e.g., North America, Latin America, Europe and the Middle East, and the Asia-Pacific region).
∙ Sizable learning and experience benefits are associated with performing an activ- ity. In some industries, learning-curve effects can allow a manufacturer to lower unit costs, boost quality, or master a new technology more quickly by concentrat- ing production in a few locations. The key to riding down the learning curve is to concentrate production in a few locations to increase the cumulative volume at a plant (and thus the experience of the plant’s workforce) as rapidly as possible.
∙ Certain locations have superior resources, allow better coordination of related activities, or offer other valuable advantages. Companies often locate a research unit or a sophisticated production facility in a particular country to take advantage of its pool of technically trained personnel. Samsung became a leader in mem- ory chip technology by establishing a major R&D facility in Silicon Valley and
INTERNATIONAL OPERATIONS AND THE QUEST FOR COMPETITIVE ADVANTAGE
LO 5
How companies are able to use international operations to improve overall competitiveness.
Companies that compete internationally can pursue competitive advantage in world markets by locating their value chain activities in whatever nations prove most advantageous.
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transferring the know-how it gained back to its operations in South Korea. Where just-in-time inventory practices yield big cost savings and/or where an assembly firm has long-term partnering arrangements with its key suppliers, parts manu- facturing plants may be clustered around final-assembly plants. A customer ser- vice center or sales office may be opened in a particular country to help cultivate strong relationships with pivotal customers located nearby.
When to Disperse Activities across Many Locations In some instances, dispersing activities across locations is more advantageous than concentrating them. Buyer-related activities—such as distribution, marketing, and after-sale service— usually must take place close to buyers. This makes it necessary to physically locate the capability to perform such activities in every country or region where a firm has major customers. For example, firms that make mining and oil-drilling equipment maintain operations in many locations around the world to support customers’ needs for speedy equipment repair and technical assistance. Large public accounting firms have offices in numerous countries to serve the foreign operations of their international corporate cli- ents. Dispersing activities to many locations is also competitively important when high transportation costs, diseconomies of large size, and trade barriers make it too expensive to operate from a central location. Many companies distribute their products from mul- tiple locations to shorten delivery times to customers. In addition, dispersing activities helps hedge against the risks of fluctuating exchange rates, supply interruptions (due to strikes, natural disasters, or transportation delays), and adverse political developments. Such risks are usually greater when activities are concentrated in a single location.
Even though global firms have strong reason to disperse buyer-related activities to many international locations, such activities as materials procurement, parts manufac- ture, finished-goods assembly, technology research, and new product development can frequently be decoupled from buyer locations and performed wherever advantage lies. Components can be made in Mexico; technology research done in Frankfurt; new products developed and tested in Phoenix; and assembly plants located in Spain, Brazil, Taiwan, or South Carolina, for example. Capital can be raised wherever it is available on the best terms.
Sharing and Transferring Resources and Capabilities across Borders to Build Competitive Advantage When a company has competitively valuable resources and capabilities, it may be able to leverage them further by expanding internationally. If its resources retain their value in foreign contexts, then entering new foreign markets can extend the com- pany’s resource-based competitive advantage over a broader domain. For example, companies like Hermes, Prada, and Gucci have utilized their powerful brand names to extend their differentiation-based competitive advantages into markets far beyond their home-country origins. In each of these cases, the luxury brand name represents a valuable competitive asset that can readily be shared by all of the company’s inter- national stores, enabling them to attract buyers and gain a higher degree of market penetration over a wider geographic area than would otherwise be possible.
Another way for a company to extend its competitive advantage internationally is to transfer technological know-how or other important resources and capabilities from its operations in one country to its operations in other countries. For instance, if a company discovers ways to assemble a product faster and more cost-effectively at one plant, then that know-how can be transferred to its assembly plants in other countries. Whirlpool, the leading global manufacturer of home appliances, with 70 manufacturing
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and technology research centers around the world, uses an online global information technology platform to quickly and effectively transfer key product innovations and improved production techniques both across national borders and across various appli- ance brands. Walmart is expanding its international operations with a strategy that involves transferring its considerable resource capabilities in distribution and discount retailing to its retail units in 28 foreign countries.
Cross-border sharing or transferring resources and capabilities provides a cost-effective way for a company to leverage its core competencies more fully and extend its competitive advantages into a wider array of geographic markets. The cost of sharing or transferring already developed resources and capabilities across country borders is low in comparison to the time and considerable expense it takes to create them. Moreover, deploying them abroad spreads the fixed development costs over a greater volume of unit sales, thus con- tributing to low unit costs and a potential cost-based competitive advantage in recently entered geographic markets. Even if the shared or transferred resources or capabilities have to be adapted to local-market conditions, this can usually be done at low additional cost.
Consider the case of Walt Disney’s theme parks as an example. The success of the theme parks in the United States derives in part from core resources such as the Disney brand name and characters like Mickey Mouse that have universal appeal and world- wide recognition. These resources can be freely shared with new theme parks as Disney expands internationally. Disney can also replicate its theme parks in new countries cost-effectively since it has already borne the costs of developing its core resources, park attractions, basic park design, and operating capabilities. The cost of replicating its theme parks abroad should be relatively low, even if the parks need to be adapted to a variety of local country conditions. By expanding internationally, Disney is able to enhance its competitive advantage over local theme park rivals. It does so by leverag- ing the differentiation advantage conferred by resources such as the Disney name and the park attractions. And by moving into new foreign markets, it augments its com- petitive advantage worldwide through the efficiency gains that come from cross-border resource sharing and low-cost capability transfer and business model replication.
Sharing and transferring resources and capabilities across country borders may also contribute to the development of broader or deeper competencies and capabilities— helping a company achieve dominating depth in some competitively valuable area. For example, the reputation for quality that Honda established worldwide began in motorcycles but enabled the company to command a position in both automobiles and outdoor power equipment in multiple-country markets. A one-country customer base is often too small to support the resource buildup needed to achieve such depth; this is particularly true in a developing or protected market, where competitively power- ful resources are not required. By deploying capabilities across a larger international domain, a company can gain the experience needed to upgrade them to a higher per- formance standard. And by facing a more challenging set of international competitors, a company may be spurred to develop a stronger set of competitive capabilities. More- over, by entering international markets, firms may be able to augment their capability set by learning from international rivals, cooperative partners, or acquisition targets.
However, cross-border resource sharing and transfers of capabilities are not guar- anteed recipes for competitive success. For example, whether a resource or capabil- ity can confer a competitive advantage abroad depends on the conditions of rivalry in each particular market. If the rivals in a foreign-country market have superior resources and capabilities, then an entering firm may find itself at a competitive dis- advantage even if it has a resource-based advantage domestically and can transfer the resources at low cost. In addition, since lifestyles and buying habits differ internation- ally, resources and capabilities that are valuable in one country may not have value in
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another. Sometimes a popular or well-regarded brand in one country turns out to have little competitive clout against local brands in other countries.
To illustrate, Netherlands-based Royal Philips Electronics, with 2012 sales of about €25 billion in more than 60 countries, is a leading seller of electric shavers, lighting products, small appliances, televisions, DVD players, and health care products. It has proven competitive capabilities in a number of businesses and countries and has been consistently profitable on a global basis. But the company’s Philips and Magnavox brand names and the resources it has invested in its North American organization have proved inadequate in changing its image as a provider of low-end TVs and DVD players, recruiting retailers that can effectively merchandise its Magnavox and Philips products, and exciting consumers with the quality and features of its products. It has lost money in North America every year since 1988.
Benefiting from Cross-Border Coordination Companies that compete on an international basis have another source of competitive advantage relative to their purely domestic rivals: They are able to benefit from coordinating activities across different countries’ domains.16 For example, an international manufacturer can shift production from a plant in one country to a plant in another to take advantage of exchange rate fluctuations, to cope with components shortages, or to profit from changing wage rates or energy costs. Production schedules can be coordinated worldwide; shipments can be diverted from one distribution center to another if sales rise unexpectedly in one place and fall in another. By coordinating their activities, international companies may also be able to enhance their leverage with host-country governments or respond adaptively to changes in tariffs and quotas. Efficiencies can also be achieved by shifting workloads from where they are unusually heavy to locations where personnel are underutilized.
CROSS-BORDER STRATEGIC MOVES While international competitors can employ any of the offensive and defensive moves discussed in Chapter 6, there are two types of strategic moves that are particularly suited for companies competing internationally. Both involve the use of “profit sanctuaries.”
Profit sanctuaries are country markets (or geographic regions) in which a com- pany derives substantial profits because of a strong or protected market position. In most cases, a company’s biggest and most strategically crucial profit sanctuary is its home market, but international and global companies may also enjoy profit sanctu- ary status in other nations where they have a strong position based on some type of competitive advantage. Companies that compete globally are likely to have more profit sanctuaries than companies that compete in just a few country markets; a domestic- only competitor, of course, can have only one profit sanctuary. Nike, which markets its products in 190 countries, has two major profit sanctuaries: North America and Greater China (where it earned $13.7 billion and $3.1 billion, respectively, in revenues in 2015).
Using Profit Sanctuaries to Wage a Strategic Offensive Profit sanctuaries are valuable competitive assets, providing the financial strength to support strategic offensives in selected country markets and fuel a company’s race for world-market leadership. The added financial capability afforded by multiple profit
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sanctuaries gives an international competitor the financial strength to wage a market offensive against a domestic competitor whose only profit sanctuary is its home mar- ket. The international company has the flexibility of lowballing its prices or launching high-cost marketing campaigns in the domestic company’s home market and grabbing market share at the domestic company’s expense. Razor-thin margins or even losses in these markets can be subsidized with the healthy profits earned in its profit sanctuaries—a practice called cross-market subsidization. The international company can adjust the depth of its price cutting to move in and capture market share quickly, or it can shave prices slightly to make gradual market inroads (per- haps over a decade or more) so as not to threaten domestic firms precipitously and trigger protectionist government actions. If the domestic company retaliates with matching price cuts or increased marketing expenses, it thereby exposes its entire revenue stream and profit base to erosion; its profits can be squeezed substantially and its competitive strength sapped, even if it is the domestic market leader.
When taken to the extreme, cut-rate pricing attacks by international competitors may draw charges of unfair “dumping.” A company is said to be dumping when it sells its goods in foreign markets at prices that are (1) well below the prices at which it normally sells them in its home market or (2) well below its full costs per unit. Almost all governments can be expected to retaliate against perceived dumping prac- tices by imposing special tariffs on goods being imported from the countries of the guilty companies. Indeed, as the trade among nations has mushroomed over the past 10 years, most governments have joined the World Trade Organization (WTO), which promotes fair trade practices among nations and actively polices dumping. Companies deemed guilty of dumping frequently come under pressure from their own govern- ment to cease and desist, especially if the tariffs adversely affect innocent companies based in the same country or if the advent of special tariffs raises the specter of an international trade war.
Using Profit Sanctuaries to Defend against International Rivals Cross-border tactics involving profit sanctuaries can also be used as a means of defending against the strategic moves of rivals with multiple profit sanctuaries of their own. If a company finds itself under competitive attack by an international rival in one country market, one way to respond is to conduct a counterattack against the rival in one of its key markets in a different country—preferably where the rival is least protected and has the most to lose. This is a possible option when rivals compete against one another in much the same markets around the world.
For companies with at least one profit sanctuary, having a presence in a rival’s key markets can be enough to deter the rival from making aggressive attacks. The reason for this is that the combination of market presence in the rival’s key markets and a profit sanctuary elsewhere can send a signal to the rival that the company could quickly ramp up production (funded by the profit sanctuary) to mount a com- petitive counterattack if the rival attacks one of the company’s key markets.
When international rivals compete against one another in multiple-country markets, this type of deterrence effect can restrain them from taking aggressive action against one another, due to the fear of a retaliatory response that might escalate the battle into a cross-border competitive war. Mutual restraint of this sort tends to stabilize the competitive position of multimarket rivals against one another. And while it may prevent each firm from making any major market
CORE CONCEPT
Cross-market subsidization—supporting competitive offensives in one market with resources and profits diverted from operations in another market—can be a powerful competitive weapon.
CORE CONCEPT
When the same companies compete against one another in multiple geographic markets, the threat of cross-border counterattacks may be enough to deter aggressive competitive moves and encourage mutual restraint among international rivals.
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share gains at the expense of its rival, it also protects against costly competitive battles that would be likely to erode the profitability of both companies without any compensating gain.
STRATEGIES FOR COMPETING IN THE MARKETS OF DEVELOPING COUNTRIES
Companies racing for global leadership have to consider competing in developing- economy markets like China, India, Brazil, Indonesia, Thailand, Poland, Mexico, and Russia—countries where the business risks are considerable but where the opportuni- ties for growth are huge, especially as their economies develop and living standards climb toward levels in the industrialized world.17 In today’s world, a company that aspires to international market leadership (or to sustained rapid growth) cannot ignore the market opportunities or the base of technical and managerial talent such countries offer. For example, in 2015 China was the world’s second-largest economy (behind the United States), based on purchasing power and its population of over 1.6 billion peo- ple. China’s growth in demand for consumer goods has made it the fifth largest market for luxury goods, with sales greater than those in developed markets such as Germany, Spain, and the United Kingdom. Thus, no company that aspires to global market lead- ership can afford to ignore the strategic importance of establishing competitive market positions in the so-called BRIC countries (Brazil, Russia, India, and China), as well as in other parts of the Asia-Pacific region, Latin America, and eastern Europe.
Tailoring products to fit market conditions in developing countries, however, often involves more than making minor product changes and becoming more familiar with local cultures. McDonald’s has had to offer vegetable burgers in parts of Asia and to rethink its prices, which are often high by local standards and affordable only by the well-to-do. Kellogg has struggled to introduce its cereals successfully because consum- ers in many less developed countries do not eat cereal for breakfast. Single-serving pack- ages of detergents, shampoos, pickles, cough syrup, and cooking oils are very popular in India because they allow buyers to conserve cash by purchasing only what they need immediately. Thus, many companies find that trying to employ a strategy akin to that used in the markets of developed countries is hazardous.18 Experimenting with some, perhaps many, local twists is usually necessary to find a strategy combination that works.
Strategy Options for Competing in Developing-Country Markets There are several options for tailoring a company’s strategy to fit the sometimes unusual or challenging circumstances presented in developing-country markets:
∙ Prepare to compete on the basis of low price. Consumers in developing markets are often highly focused on price, which can give low-cost local competitors the edge unless a company can find ways to attract buyers with bargain prices as well as better products. For example, in order to enter the market for laundry detergents in India, Unilever had to develop a low-cost detergent (named Wheel), construct new low-cost production facilities, package the detergent in single-use amounts so that it could be sold at a very low unit price, distribute the product to local merchants by
LO 6
The unique characteristics of competing in developing-country markets.
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handcarts, and craft an economical marketing campaign that included painted signs on buildings and demonstrations near stores. The new brand quickly captured $100 million in sales and by 2014 was the top detergent brand in India based dollar sales. Unilever replicated the strategy in India with low-priced packets of shampoos and deodorants and in South America with a detergent brand-named Ala.
∙ Modify aspects of the company’s business model to accommodate the unique local circumstances of developing countries. For instance, Honeywell had sold industrial products and services for more than 100 years outside the United States and Europe using a foreign subsidiary model that focused international activi- ties on sales only. When Honeywell entered China, it discovered that industrial customers in that country considered how many key jobs foreign companies cre- ated in China, in addition to the quality and price of the product or service when making purchasing decisions. Honeywell added about 150 engineers, strategists, and marketers in China to demonstrate its commitment to bolstering the Chinese economy. Honeywell replicated its “East for East” strategy when it entered the market for industrial products and services in India. Within 10 years of Honeywell establishing operations in China and three years of expanding into India, the two emerging markets accounted for 30 percent of the firm’s worldwide growth.
∙ Try to change the local market to better match the way the company does busi- ness elsewhere. An international company often has enough market clout to drive major changes in the way a local country market operates. When Japan’s Suzuki entered India, it triggered a quality revolution among Indian auto parts manufac- turers. Local component suppliers teamed up with Suzuki’s vendors in Japan and worked with Japanese experts to produce higher-quality products. Over the next two decades, Indian companies became proficient in making top-notch compo- nents for vehicles, won more prizes for quality than companies in any country other than Japan, and broke into the global market as suppliers to many automak- ers in Asia and other parts of the world. Mahindra and Mahindra, one of India’s premier automobile manufacturers, has been recognized by a number of organiza- tions for its product quality. Among its most noteworthy awards was its number- one ranking by J.D. Power Asia Pacific for new-vehicle overall quality.
∙ Stay away from developing markets where it is impractical or uneconomical to modify the company’s business model to accommodate local circumstances. Home Depot’s executive vice president and CFO, Carol Tomé, argues that there are few developing countries where Home Depot can operate successfully.19 The company expanded successfully into Mexico, but it has avoided entry into other developing countries because its value proposition of good quality, low prices, and attentive customer service relies on (1) good highways and logistical systems to minimize store inventory costs, (2) employee stock ownership to help motivate store personnel to provide good customer service, and (3) high labor costs for housing construction and home repairs that encourage homeowners to engage in do-it-yourself projects. Relying on these factors in North American markets has worked spectacularly for Home Depot, but the company found that it could not count on these factors in China, from which it withdrew in 2012.
Company experiences in entering developing markets like Argentina, Vietnam, Malaysia, and Brazil indicate that profitability seldom comes quickly or easily. Building a market for the company’s products can often turn into a long-term process that involves reeducation of consumers, sizable investments in adver- tising to alter tastes and buying habits, and upgrades of the local infrastructure
Profitability in developing markets rarely comes quickly or easily—new entrants have to adapt their business models to local conditions, which may not always be possible.
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(transportation systems, distribution channels, etc.). In such cases, a company must be patient, work within the system to improve the infrastructure, and lay the foundation for generating sizable revenues and profits once conditions are ripe for market takeoff.
DEFENDING AGAINST GLOBAL GIANTS: STRATEGIES FOR LOCAL COMPANIES IN DEVELOPING COUNTRIES
If opportunity-seeking, resource-rich international companies are looking to enter developing-country markets, what strategy options can local companies use to survive? As it turns out, the prospects for local companies facing global giants are by no means grim. Studies of local companies in developing markets have disclosed five strategies that have proved themselves in defending against globally competitive companies.20
1. Develop business models that exploit shortcomings in local distribution networks or infrastructure. In many instances, the extensive collection of resources pos- sessed by the global giants is of little help in building a presence in developing markets. The lack of well-established local wholesaler and distributor networks, telecommunication systems, consumer banking, or media necessary for advertis- ing makes it difficult for large internationals to migrate business models proved in developed markets to emerging markets. Emerging markets sometimes favor local companies whose managers are familiar with the local language and culture and are skilled in selecting large numbers of conscientious employees to carry out labor-intensive tasks. Shanda, a Chinese producer of massively multiplayer online role-playing games (MMORPGs), overcame China’s lack of an established credit card network by selling prepaid access cards through local merchants. The compa- ny’s focus on online games also protects it from shortcomings in China’s software piracy laws. An India-based electronics company carved out a market niche for itself by developing an all-in-one business machine, designed especially for India’s millions of small shopkeepers, that tolerates the country’s frequent power outages.
2. Utilize keen understanding of local customer needs and preferences to create cus- tomized products or services. When developing-country markets are largely made up of customers with strong local needs, a good strategy option is to concentrate on customers who prefer a local touch and to accept the loss of the customers attracted to global brands.21 A local company may be able to astutely exploit its local orientation—its familiarity with local preferences, its expertise in traditional products, its long-standing customer relationships. A small Middle Eastern cell phone manufacturer competes successfully against industry giants Samsung, Apple, Nokia, and Motorola by selling a model designed especially for Muslims— it is loaded with the Koran, alerts people at prayer times, and is equipped with a compass that points them toward Mecca. Shenzhen-based Tencent has become the leader in instant messaging in China through its unique understanding of Chinese behavior and culture.
3. Take advantage of aspects of the local workforce with which large international companies may be unfamiliar. Local companies that lack the technological capa- bilities of foreign entrants may be able to rely on their better understanding of the local labor force to offset any disadvantage. Focus Media is China’s largest outdoor advertising firm and has relied on low-cost labor to update its more than 170,000 LCD displays and billboards in over 90 cities in a low-tech manner, while
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international companies operating in China use electronically networked screens that allow messages to be changed remotely. Focus uses an army of employees who ride to each display by bicycle to change advertisements with programming contained on a USB flash drive or DVD. Indian information technology firms such as Infosys Technologies and Satyam Computer Services have been able to keep their personnel costs lower than those of international competitors EDS and Accenture because of their familiarity with local labor markets. While the large internationals have focused recruiting efforts in urban centers like Bangalore and Delhi, driving up engineering and computer science salaries in such cities, local companies have shifted recruiting efforts to second-tier cities that are unfamiliar to foreign firms.
4. Use acquisition and rapid-growth strategies to better defend against expansion- minded internationals. With the growth potential of developing markets such as China, Indonesia, and Brazil obvious to the world, local companies must attempt to develop scale and upgrade their competitive capabilities as quickly as possible to defend against the stronger international’s arsenal of resources. Most success- ful companies in developing markets have pursued mergers and acquisitions at a rapid-fire pace to build first a nationwide and then an international presence. Hindalco, India’s largest aluminum producer, has followed just such a path to achieve its ambitions for global dominance. By acquiring companies in India first, it gained enough experience and confidence to eventually acquire much larger foreign companies with world-class capabilities.22 When China began to liberalize its foreign trade policies, Lenovo (the Chinese PC maker) realized that its long- held position of market dominance in China could not withstand the onslaught of new international entrants such as Dell and HP. Its acquisition of IBM’s PC busi- ness allowed Lenovo to gain rapid access to IBM’s globally recognized PC brand, its R&D capability, and its existing distribution in developed countries. This has allowed Lenovo not only to hold its own against the incursion of global giants into its home market but also to expand into new markets around the world.23
5. Transfer company expertise to cross-border markets and initiate actions to con- tend on an international level. When a company from a developing country has resources and capabilities suitable for competing in other country markets, launching initiatives to transfer its expertise to foreign markets becomes a viable strategic option. Televisa, Mexico’s largest media company, used its expertise in Spanish culture and linguistics to become the world’s most prolific producer of Spanish-language soap operas. By continuing to upgrade its capabilities and learn from its experience in foreign markets, a company can sometimes transform itself into one capable of competing on a worldwide basis, as an emerging global giant. Sundaram Fasteners of India began its foray into foreign markets as a supplier of radiator caps to General Motors—an opportunity it pursued when GM first decided to outsource the production of this part. As a participant in GM’s supplier network, the company learned about emerging technical standards, built its capa- bilities, and became one of the first Indian companies to achieve QS 9000 quality certification. With the expertise it gained and its recognition for meeting quality standards, Sundaram was then able to pursue opportunities to supply automotive parts in Japan and Europe.
Illustration Capsule 7.3 discusses how a travel agency in China used a combina- tion of these strategies to become that country’s largest travel consolidator and online travel agent.
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Ctrip has utilized a business model tailored to the Chinese travel market, its access to low-cost labor, and its unique understanding of customer preferences and buy- ing habits to build scale rapidly and defeat foreign rivals such as Expedia and Travelocity in becoming the larg- est travel agency in China. The company was founded in 1999 with a focus on business travelers, since corpo- rate travel accounts for the majority of China’s travel bookings. The company initially placed little emphasis on online transactions because at the time there was no national ticketing system in China, most hotels did not belong to a national or international chain, and most consumers preferred paper tickets to electronic tickets. To overcome this infrastructure shortcoming and enter the online market, the company established its own cen- tral database of 5,600 hotels located throughout China and flight information for all major airlines operating in China. Ctrip set up a call center of 3,000 representa- tives that could use its proprietary database to provide travel information for up to 100,000 customers per day.
Because most of its transactions were not done over the Internet at the start, the company hired couriers in all major cities in China to ride by bicycle or scooter to col- lect payments and deliver tickets to Ctrip’s corporate customers. Ctrip also initiated a loyalty program that provided gifts and incentives to the administrative per- sonnel who arranged travel for business executives, who were more likely to use online services. By 2011, Ctrip. com held 60 percent of China’s online travel market, having grown 40 percent every year since 1999, leading to a market cap coming close to those of some major U.S. online travel agencies.
However, the phenomenal growth of the Chinese market for such travel agency services, along with changing technological ability and preferences, has led to a new type of competition: online, and more pivotally, mobile travel booking. Dominance in the mobile space drove a competitor, Qunar, to experience a huge surge in growth. While this competition was a negative in the traditional financial sense for Ctrip, analysts believe that new technology has ended up benefiting the entire industry. Additionally, this has provided the two compa- nies with the opportunity to utilize another important local strategy to grow and remain competitive against global firms—a partnership, which Ctrip and Qunar undertook in 2013, combining their unique advantages to cross-sell travel products. The solidity of this partner- ship was furthered in late 2015, when the two companies agreed to an alliance through the exchange of shares in one another’s companies. Together, the two companies control more than 80 percent of China’s hotel and air ticket markets. The long-term effects of the new agree- ment still have yet to be seen, but the success of Ctrip has demonstrated the potential benefits of an effective local-market strategy.
© Nelson Ching/Bloomberg via Getty Images
Note: Developed with Harold W. Greenstone.
Sources: Arindam K. Bhattacharya and David C. Michael, “How Local Companies Keep Multinationals at Bay,” Harvard Business Review 86, no. 3 (March 2008), pp. 85–95; B. Perez, “Ctrip Likely to Gain More Business from Stronger Qunar Platform,” South China Morning Press online, October 2, 2013 (accessed April 3, 2014); B. Cao, “Qunar Jumps on Mobile User Growth as Ctrip Tumbles,” Bloomberg online, January 5, 2014 (accessed April 3, 2014); www.thatsmags.com/shanghai/article/detail/480/a-journey-with-ctrip; money.cnn.com/quote/ quote.html?symb5EXPE (accessed March 28, 2012).
ILLUSTRATION CAPSULE 7.3
How Ctrip Successfully Defended against International Rivals to Become China’s Largest Online Travel Agency
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KEY POINTS
1. Competing in international markets allows a company to (1) gain access to new customers; (2) achieve lower costs through greater economies of scale, learning, and increased purchasing power; (3) gain access to low-cost inputs of production; (4) further exploit its core competencies; and (5) gain access to resources and capabilities located outside the company’s domestic market.
2. Strategy making is more complex for five reasons: (1) Different countries have home-country advantages in different industries; (2) there are location-based advantages to performing different value chain activities in different parts of the world; (3) varying political and economic risks make the business climate of some countries more favorable than others; (4) companies face the risk of adverse shifts in exchange rates when operating in foreign countries; and (5) differences in buyer tastes and preferences present a conundrum concerning the trade-off between cus- tomizing and standardizing products and services.
3. The strategies of firms that expand internationally are usually grounded in home- country advantages concerning demand conditions; factor conditions; related and supporting industries; and firm strategy, structure, and rivalry, as described by the Diamond of National Competitive Advantage framework.
4. There are five strategic options for entering foreign markets. These include maintain- ing a home-country production base and exporting goods to foreign markets, licensing foreign firms to produce and distribute the company’s products abroad, employing a franchising strategy, establishing a foreign subsidiary via an acquisition or greenfield venture, and using strategic alliances or other collaborative partnerships.
5. A company must choose among three alternative approaches for competing internationally: (1) a multidomestic strategy—a think-local, act-local approach to crafting international strategy; (2) a global strategy—a think-global, act- global approach; and (3) a combination think-global, act-local approach, known as a transnational strategy. A multidomestic strategy (think local, act local) is appropriate for companies that must vary their product offerings and competi- tive approaches from country to country in order to accommodate different buyer preferences and market conditions. The global strategy (think global, act global) works best when there are substantial cost benefits to be gained from taking a standardized, globally integrated approach and there is little need for local respon- siveness. A transnational strategy (think global, act local) is called for when there is a high need for local responsiveness as well as substantial benefits from taking a globally integrated approach. In this approach, a company strives to employ the same basic competitive strategy in all markets but still customizes its product offering and some aspect of its operations to fit local market circumstances.
6. There are three general ways in which a firm can gain competitive advantage (or offset domestic disadvantages) in international markets. One way involves locat- ing various value chain activities among nations in a manner that lowers costs or achieves greater product differentiation. A second way draws on an interna- tional competitor’s ability to extend its competitive advantage by cost-effectively sharing, replicating, or transferring its most valuable resources and capabilities across borders. A third looks for benefits from cross-border coordination that are unavailable to domestic-only competitors.
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7. Two types of strategic moves are particularly suited for companies competing internationally. Both involve the use of profit sanctuaries—country markets where a company derives substantial profits because of its strong or protected market position. Profit sanctuaries are useful in waging strategic offenses in international markets through cross-subsidization—a practice of supporting competitive offen- sives in one market with resources and profits diverted from operations in another market (the profit sanctuary). They may be used defensively to encourage mutual restraint among competitors when there is international multimarket competition by signaling that each company has the financial capability for mounting a strong counterattack if threatened. For companies with at least one profit sanctuary, hav- ing a presence in a rival’s key markets can be enough to deter the rival from mak- ing aggressive attacks.
8. Companies racing for global leadership have to consider competing in develop- ing markets like the BRIC countries—Brazil, Russia, India, and China—where the business risks are considerable but the opportunities for growth are huge. To succeed in these markets, companies often have to (1) compete on the basis of low price, (2) modify aspects of the company’s business model to accommodate local circumstances, and/or (3) try to change the local market to better match the way the company does business elsewhere. Profitability is unlikely to come quickly or easily in developing markets, typically because of the investments needed to alter buying habits and tastes, the increased political and economic risk, and/or the need for infrastructure upgrades. And there may be times when a company should simply stay away from certain developing markets until conditions for entry are better suited to its business model and strategy.
9. Local companies in developing-country markets can seek to compete against large international companies by (1) developing business models that exploit shortcom- ings in local distribution networks or infrastructure, (2) utilizing a superior under- standing of local customer needs and preferences or local relationships, (3) taking advantage of competitively important qualities of the local workforce with which large international companies may be unfamiliar, (4) using acquisition strategies and rapid-growth strategies to better defend against expansion-minded interna- tional companies, or (5) transferring company expertise to cross-border markets and initiating actions to compete on an international level.
ASSURANCE OF LEARNING EXERCISES
1. L’Oréal markets 32 brands of cosmetics, fragrances, and hair care products in 130 countries. The company’s international strategy involves manufacturing these products in 40 plants located around the world. L’Oréal’s international strategy is discussed in its operations section of the company’s website (www.loreal.com/ careers/who-you-can-be/operations) and in its press releases, annual reports, and presentations. Why has the company chosen to pursue a foreign subsidiary strategy? Are there strategic advantages to global sourcing and production in the cosmetics, fragrances, and hair care products industry relative to an export strategy?
LO 1, LO 3
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2. Alliances, joint ventures, and mergers with foreign companies are widely used as a means of entering foreign markets. Such arrangements have many purposes, including learning about unfamiliar environments, and the opportunity to access the complementary resources and capabilities of a foreign partner. Illustration Capsule 7.1 provides an example of how Walgreens used a strategy of entering foreign markets via alliance, followed by a merger with the same entity. What was this entry strategy designed to achieve, and why would this make sense for a com- pany like Walgreens?
3. Assume you are in charge of developing the strategy for an international company selling products in some 50 different countries around the world. One of the issues you face is whether to employ a multidomestic strategy, a global strategy, or a transnational strategy.
a. If your company’s product is mobile phones, which of these strategies do you think it would make better strategic sense to employ? Why?
b. If your company’s product is dry soup mixes and canned soups, would a multi- domestic strategy seem to be more advisable than a global strategy or a trans- national strategy? Why or why not?
c. If your company’s product is large home appliances such as washing machines, ranges, ovens, and refrigerators, would it seem to make more sense to pursue a multidomestic strategy, a global strategy, or a transnational strategy? Why?
4. Using your university library’s subscription to LexisNexis, EBSCO, or a similar database, identify and discuss three key strategies that Volkswagen is using to compete in China.
LO 1, LO 3
LO 2, LO 4
LO 5, LO 6
EXERCISE FOR SIMULATION PARTICIPANTS
The following questions are for simulation participants whose companies operate in an international market arena. If your company competes only in a single country, then skip the questions in this section.
1. To what extent, if any, have you and your co-managers adapted your company’s strat- egy to take shifting exchange rates into account? In other words, have you under- taken any actions to try to minimize the impact of adverse shifts in exchange rates?
2. To what extent, if any, have you and your co-managers adapted your company’s strategy to take geographic differences in import tariffs or import duties into account?
3. Which one of the following best describes the strategic approach your company is taking in trying to compete successfully on an international basis?
∙ Multidomestic or think-local, act-local approach. ∙ Global or think-global, act-global approach. ∙ Transnational or think-global, act-local approach.
Explain your answer and indicate two or three chief elements of your company’s strategy for competing in two or more different geographic regions.
LO 2
LO 2
LO 4
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ENDNOTES 8 K. W. Glaister and P. J. Buckley, “Strategic Motives for International Alliance Formation,” Journal of Management Studies 33, no. 3 (May 1996), pp. 301–332. 9 Jeffrey H. Dyer, Prashant Kale, and Harbir Singh, “When to Ally and When to Acquire,” Harvard Business Review 82, no. 7–8 (July–August 2004). 10 Yves Doz and Gary Hamel, Alliance Advan- tage: The Art of Creating Value through Partnering (Harvard Business School Press, 1998); Rosabeth Moss Kanter, “Collaborative Advantage: The Art of the Alliance,” Harvard Business Review 72, no. 4 (July–August 1994), pp. 96–108. 11 Jeremy Main, “Making Global Alliances Work,” Fortune, December 19, 1990, p. 125. 12 C. K. Prahalad and Kenneth Lieberthal, “The End of Corporate Imperialism,” Harvard Business Review 81, no. 8 (August 2003), pp. 109–117. 13 Pankaj Ghemawat, “Managing Differences: The Central Challenge of Global Strategy,” Harvard Business Review 85, no. 3 (March 2007). 14 C. A. Bartlett and S. Ghoshal, Managing across Borders: The Transnational Solution, 2nd ed. (Boston: Harvard Business School Press, 1998). 15 Lynn S. Paine, “The China Rules,” Harvard Business Review 88, no. 6 (June 2010), pp. 103–108. 16 C. K. Prahalad and Yves L. Doz, The Multina- tional Mission: Balancing Local Demands and Global Vision (New York: Free Press, 1987). 17 David J. Arnold and John A. Quelch, “New Strategies in Emerging Markets,” Sloan
1 Sidney G. Winter and Gabriel Szulanski, “ Getting It Right the Second Time,” Harvard Business Review 80, no. 1 (January 2002), pp. 62–69. 2 P. Dussauge, B. Garrette, and W. Mitchell, “Learning from Competing Partners: Outcomes and Durations of Scale and Link Alliances in Europe, North America and Asia,” Strategic Management Journal 21, no. 2 (February 2000), pp. 99–126; K. W. Glaister and P. J. Buckley, “Strategic Motives for International Alliance Formation,” Journal of Management Studies 33, no. 3 (May 1996), pp. 301–332. 3 Michael E. Porter, “The Competitive Advan- tage of Nations,” Harvard Business Review, March–April 1990, pp. 73–93. 4 Tom Mitchell and Avantika Chilkoti, “China Car Sales Accelerate Away from US and Brazil in 2013,” Financial Times, January 9, 2014, www.ft.com/cms/s/0/8c649078-78f8-11e3- b381-00144feabdc0.html#axzz2rpEq jkZO. 5 U.S. Department of Labor, Bureau of Labor Statistics, “International Comparisons of Hourly Compensation Costs in Manufacturing 2012,” August 9, 2013. (The numbers for India and China are estimates.) 6 Sangwon Yoon, “South Korea Targets Internet Addicts; 2 Million Hooked,” Valley News, April 25, 2010, p. C2. 7 Joel Bleeke and David Ernst, “The Way to Win in Cross-Border Alliances,” Harvard Business Review 69, no. 6 (November–December 1991), pp. 127-133; Gary Hamel, Yves L. Doz, and C. K. Prahalad, “Collaborate with Your Competitors– and Win,” Harvard Business Review 67, no. 1 (January–February 1989), pp. 134–135.
Management Review 40, no. 1 (Fall 1998), pp. 7–20. 18 Tarun Khanna, Krishna G. Palepu, and Jayant Sinha, “Strategies That Fit Emerging Markets,” Harvard Business Review 83, no. 6 (June 2005), p. 63; Arindam K. Bhattacharya and David C. Michael, “How Local Companies Keep Multinationals at Bay,” Harvard Business Review 86, no. 3 (March 2008), pp. 94–95. 19 www.ajc.com/news/business/home-depot- eschews-large-scale-international-expan/ nSQBh/ (accessed February 2, 2014). 20 Tarun Khanna and Krishna G. Palepu, “Emerging Giants: Building World-Class Com- panies in Developing Countries,” Harvard Business Review 84, no. 10 (October 2006), pp. 60–69. 21 Niroj Dawar and Tony Frost, “Competing with Giants: Survival Strategies for Local Compa- nies in Emerging Markets,” Harvard Business Review 77, no. 1 (January-February 1999), p. 122; Guitz Ger, “Localizing in the Global Village: Local Firms Competing in Global Markets,” California Management Review 41, no. 4 (Summer 1999), pp. 64–84. 22 N. Kumar, “How Emerging Giants Are Rewrit- ing the Rules of M&A,” Harvard Business Review, May 2009, pp. 115–121. 23 H. Rui and G. Yip, “Foreign Acquisitions by Chinese Firms: A Strategic Intent Perspective,” Journal of World Business 43 (2008), pp. 213–226.
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CHAPTER 8
Corporate Strategy Diversification and the Multibusiness Company
Learning Objectives
THIS CHAPTER WILL HELP YOU UNDERSTAND:
LO 1 When and how business diversification can enhance shareholder value.
LO 2 How related diversification strategies can produce cross-business strategic fit capable of delivering competitive advantage.
LO 3 The merits and risks of unrelated diversification strategies.
LO 4 The analytic tools for evaluating a company’s diversification strategy.
LO 5 What four main corporate strategy options a diversified company can employ for solidifying its strategy and improving company performance.
© Roy Scott/Ikon Images/age fotostock
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The roll of takeovers is to improve unsatisfactory com- panies and to allow healthy companies to grow strate- gically by acquisitions.
Sir James Goldsmith—Billionaire financier
Make winners out of every business in your company. Don’t carry losers.
Jack Welch—Legendary CEO of General Electric
Fit between a parent and its businesses is a two-edged sword: A good fit can create value; a bad one can destroy it.
Andrew Campbell, Michael Goold, and Marcus
Alexander—Academics, authors, and consultants
The task of crafting a diversified company’s overall corporate strategy falls squarely in the lap of top-level executives and involves three distinct facets:
1. Picking new industries to enter and deciding on the means of entry. Pursuing a diversification strategy requires that management decide which new industries to enter and then, for each new industry, whether to enter by starting a new business
WHAT DOES CRAFTING A DIVERSIFICATION STRATEGY ENTAIL?
This chapter moves up one level in the strategy- making hierarchy, from strategy making in a single-business enterprise to strategy making in a diversified enterprise. Because a diversified com- pany is a collection of individual businesses, the strategy-making task is more complicated. In a one-business company, managers have to come up with a plan for competing successfully in only a single industry environment—the result is what Chapter 2 labeled as business strategy (or business- level strategy). But in a diversified company, the strategy-making challenge involves assessing mul- tiple industry environments and developing a set of business strategies, one for each industry arena in which the diversified company operates. And top executives at a diversified company must still go
one step further and devise a companywide (or corporate) strategy for improving the performance of the company’s overall business lineup and for making a rational whole out of its diversified collec- tion of individual businesses.
In the first portion of this chapter, we describe what crafting a diversification strategy entails, when and why diversification makes good strategic sense, the various approaches to diversifying a company’s business lineup, and the pros and cons of related versus unrelated diversification strategies. The sec- ond part of the chapter looks at how to evaluate the attractiveness of a diversified company’s business lineup, how to decide whether it has a good diversifi- cation strategy, and the strategic options for improv- ing a diversified company’s future performance.
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As long as a company has plentiful opportunities for profitable growth in its present industry, there is no urgency to pursue diversification. But growth opportunities are often limited in mature industries and markets where buyer demand is flat or declin- ing. In addition, changing industry conditions—new technologies, inroads being made by substitute products, fast-shifting buyer preferences, or intensifying competition— can undermine a company’s ability to deliver ongoing gains in revenues and profits. Consider, for example, what the growing use of debit cards and online bill payment has done to the check-printing business and what mobile phone companies and mar- keters of Voice over Internet Protocol (VoIP) have done to the revenues of long- distance providers such as AT&T, British Telecommunications, and NTT in Japan. Thus, diversifying into new industries always merits strong consideration whenever a single-business company encounters diminishing market opportunities and stagnating sales in its principal business.
The decision to diversify presents wide-ranging possibilities. A company can diversify into closely related businesses or into totally unrelated businesses. It can diversify its present revenue and earnings base to a small or major extent. It can move into one or two large new businesses or a greater number of small ones. It can achieve diversification by acquiring an existing company, starting up a new business from
from the ground up, by acquiring a company already in the target industry, or by forming a joint venture or strategic alliance with another company.
2. Pursuing opportunities to leverage cross-business value chain relationships, where there is strategic fit, into competitive advantage. The task here is to determine whether there are opportunities to strengthen a diversified company’s businesses by such means as transferring competitively valuable resources and capabilities from one business to another, combining the related value chain activities of dif- ferent businesses to achieve lower costs, sharing the use of a powerful and well- respected brand name across multiple businesses, and encouraging knowledge sharing and collaborative activity among the businesses.
3. Initiating actions to boost the combined performance of the corporation’s col- lection of businesses. Strategic options for improving the corporation’s overall performance include (1) sticking closely with the existing business lineup and pursuing opportunities presented by these businesses, (2) broadening the scope of diversification by entering additional industries, (3) retrenching to a narrower scope of diversification by divesting either poorly performing businesses or those that no longer fit into management’s long-range plans, and (4) broadly restructur- ing the entire company by divesting some businesses, acquiring others, and reor- ganizing, to put a whole new face on the company’s business lineup.
The demanding and time-consuming nature of these four tasks explains why cor- porate executives generally refrain from becoming immersed in the details of crafting and executing business-level strategies. Rather, the normal procedure is to delegate lead responsibility for business strategy to the heads of each business, giving them the latitude to develop strategies suited to the particular industry environment in which their business operates and holding them accountable for producing good financial and strategic results.
WHEN TO CONSIDER DIVERSIFYING
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Diversification must do more for a company than simply spread its business risk across various industries. In principle, diversification cannot be considered wise or justifiable unless it results in added long-term economic value for shareholders— value that shareholders cannot capture on their own by purchasing stock in companies in different industries or investing in mutual funds to spread their investments across several industries. A move to diversify into a new business stands little chance of building shareholder value without passing the following three Tests of Corporate Advantage.1
1. The industry attractiveness test. The industry to be entered through diversifica- tion must be structurally attractive (in terms of the five forces), have resource requirements that match those of the parent company, and offer good prospects for growth, profitability, and return on investment.
2. The cost of entry test. The cost of entering the target industry must not be so high as to exceed the potential for good profitability. A catch-22 can prevail here, however. The more attractive an industry’s prospects are for growth and good long-term profitability, the more expensive it can be to enter. Entry bar- riers for startup companies are likely to be high in attractive industries—if bar- riers were low, a rush of new entrants would soon erode the potential for high profitability. And buying a well-positioned company in an appealing indus- try often entails a high acquisition cost that makes passing the cost of entry test less likely. Since the owners of a successful and growing company usually demand a price that reflects their business’s profit prospects, it’s easy for such an acquisition to fail the cost of entry test.
3. The better-off test. Diversifying into a new business must offer potential for the company’s existing businesses and the new business to perform better together under a single corporate umbrella than they would perform operating as inde- pendent, stand-alone businesses—an effect known as synergy. For example, let’s say that company A diversifies by purchasing company B in another indus- try. If A and B’s consolidated profits in the years to come prove no greater than what each could have earned on its own, then A’s diversification won’t provide its shareholders with any added value. Company A’s shareholders could have achieved the same 1 + 1 = 2 result by merely purchasing stock in company B. Diversification does not result in added long-term value for shareholders unless it produces a 1 + 1 = 3 effect, whereby the businesses perform better together as part of the same firm than they could have performed as indepen- dent companies.
Diversification moves must satisfy all three tests to grow shareholder value over the long term. Diversification moves that can pass only one or two tests are suspect.
CORE CONCEPT
To add shareholder value, a move to diversify into a new business must pass the three Tests of Corporate Advantage: 1. The industry
attractiveness test 2. The cost of entry test 3. The better-off test
CORE CONCEPT
Creating added value for shareholders via diversification requires building a multibusiness company in which the whole is greater than the sum of its parts; such 1 + 1 = 3 effects are called synergy.
BUILDING SHAREHOLDER VALUE: THE ULTIMATE JUSTIFICATION FOR DIVERSIFYING
LO 1
When and how business diversification can enhance shareholder value.
scratch, or forming a joint venture with one or more companies to enter new busi- nesses. In every case, however, the decision to diversify must start with a strong economic justification for doing so.
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The means of entering new businesses can take any of three forms: acquisition, inter- nal startup, or joint ventures with other companies.
Diversifying by Acquisition of an Existing Business Acquisition is a popular means of diversifying into another industry. Not only is it quicker than trying to launch a new operation, but it also offers an effective way
to hurdle such entry barriers as acquiring technological know-how, establish- ing supplier relationships, achieving scale economies, building brand awareness, and securing adequate distribution. Acquisitions are also commonly employed to access resources and capabilities that are complementary to those of the acquiring firm and that cannot be developed readily internally. Buying an ongoing operation allows the acquirer to move directly to the task of building a strong market posi- tion in the target industry, rather than getting bogged down in trying to develop the knowledge, experience, scale of operation, and market reputation necessary for a startup entrant to become an effective competitor.
However, acquiring an existing business can prove quite expensive. The costs of acquiring another business include not only the acquisition price but also the
costs of performing the due diligence to ascertain the worth of the other company, the costs of negotiating the purchase transaction, and the costs of integrating the business into the diversified company’s portfolio. If the company to be acquired is a successful company, the acquisition price will include a hefty premium over the preacquisition value of the company for the right to control the company. For example, the $28 billion that Berkshire Hathaway and 3G Capital agreed to pay for H. J. Heinz Company in 2014 included a 30 percent premium over its one-year average share price.2 Premiums are paid in order to convince the shareholders and managers of the target company that it is in their financial interests to approve the deal. The average premium paid by U.S. companies was 19 percent in 2013, but it was more often in the 20 to 25 percent range over the last 10 years.3
While acquisitions offer an enticing means for entering a new business, many fail to deliver on their promise.4 Realizing the potential gains from an acquisition requires
a successful integration of the acquired company into the culture, systems, and structure of the acquiring firm. This can be a costly and time-consuming opera- tion. Acquisitions can also fail to deliver long-term shareholder value if the acquirer overestimates the potential gains and pays a premium in excess of the realized gains. High integration costs and excessive price premiums are two reasons that an acquisition might fail the cost of entry test. Firms with significant experience in making acquisitions are better able to avoid these types of problems.5
Entering a New Line of Business through Internal Development Achieving diversification through internal development involves starting a new business subsidiary from scratch. Internal development has become an increasingly important way for companies to diversify and is often referred to as corporate venturing or new venture development. Although building a new business from the ground up is generally a time-consuming and uncertain process, it avoids the
CORE CONCEPT
An acquisition premium, or control premium, is the amount by which the price offered exceeds the preacquisition market value of the target company.
CORE CONCEPT
Corporate venturing (or new venture development) is the process of developing new businesses as an outgrowth of a company’s established business operations. It is also referred to as corporate entrepreneurship or intrapreneurship since it requires entrepreneurial- like qualities within a larger enterprise.
APPROACHES TO DIVERSIFYING THE BUSINESS LINEUP
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pitfalls associated with entry via acquisition and may allow the firm to realize greater profits in the end. It may offer a viable means of entering a new or emerging industry where there are no good acquisition candidates.
Entering a new business via internal development, however, poses some signifi- cant hurdles. An internal new venture not only has to overcome industry entry bar- riers but also must invest in new production capacity, develop sources of supply, hire and train employees, build channels of distribution, grow a customer base, and so on, unless the new business is quite similar to the company’s existing business. The risks associated with internal startups can be substantial, and the likelihood of failure is often high. Moreover, the culture, structures, and organizational systems of some companies may impede innovation and make it difficult for corporate entre- preneurship to flourish.
Generally, internal development of a new business has appeal only when (1) the parent company already has in-house most of the resources and capabilities it needs to piece together a new business and compete effectively; (2) there is ample time to launch the business; (3) the internal cost of entry is lower than the cost of entry via acquisition; (4) adding new production capacity will not adversely impact the supply– demand balance in the industry; and (5) incumbent firms are likely to be slow or ineffective in responding to a new entrant’s efforts to crack the market.
Using Joint Ventures to Achieve Diversification Entering a new business via a joint venture can be useful in at least three types of situations.6 First, a joint venture is a good vehicle for pursuing an opportunity that is too complex, uneconomical, or risky for one company to pursue alone. Second, joint ventures make sense when the opportunities in a new industry require a broader range of competencies and know-how than a company can marshal on its own. Many of the opportunities in satellite-based telecommunications, biotechnology, and network- based systems that blend hardware, software, and services call for the coordinated development of complementary innovations and the tackling of an intricate web of financial, technical, political, and regulatory factors simultaneously. In such cases, pooling the resources and competencies of two or more companies is a wiser and less risky way to proceed. Third, companies sometimes use joint ventures to diversify into a new industry when the diversification move entails having operations in a foreign country. However, as discussed in Chapters 6 and 7, partnering with another company has significant drawbacks due to the potential for conflicting objectives, disagree- ments over how to best operate the venture, culture clashes, and so on. Joint ventures are generally the least durable of the entry options, usually lasting only until the part- ners decide to go their own ways.
Choosing a Mode of Entry The choice of how best to enter a new business—whether through internal devel- opment, acquisition, or joint venture—depends on the answers to four important questions: ∙ Does the company have all of the resources and capabilities it requires to enter the
business through internal development, or is it lacking some critical resources? ∙ Are there entry barriers to overcome? ∙ Is speed an important factor in the firm’s chances for successful entry? ∙ Which is the least costly mode of entry, given the company’s objectives?
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The Question of Critical Resources and Capabilities If a firm has all the resources it needs to start up a new business or will be able to easily pur- chase or lease any missing resources, it may choose to enter the business via inter- nal development. However, if missing critical resources cannot be easily purchased or leased, a firm wishing to enter a new business must obtain these missing resources through either acquisition or joint venture. Bank of America acquired Merrill Lynch to obtain critical investment banking resources and capabilities that it lacked. The acqui- sition of these additional capabilities complemented Bank of America’s strengths in corporate banking and opened up new business opportunities for the company. Firms often acquire other companies as a way to enter foreign markets where they lack local marketing knowledge, distribution capabilities, and relationships with local suppli- ers or customers. McDonald’s acquisition of Burghy, Italy’s only national hamburger chain, offers an example.7 If there are no good acquisition opportunities or if the firm wants to avoid the high cost of acquiring and integrating another firm, it may choose to enter via joint venture. This type of entry mode has the added advantage of spreading the risk of entering a new business, an advantage that is particularly attractive when uncertainty is high. De Beers’s joint venture with the luxury goods company LVMH provided De Beers not only with the complementary marketing capabilities it needed to enter the diamond retailing business but also with a partner to share the risk.
The Question of Entry Barriers The second question to ask is whether entry barriers would prevent a new entrant from gaining a foothold and succeeding in the industry. If entry barriers are low and the industry is populated by small firms, internal development may be the preferred mode of entry. If entry barriers are high, the company may still be able to enter with ease if it has the requisite resources and capabilities for overcoming high barriers. For example, entry barriers due to reputa- tional advantages may be surmounted by a diversified company with a widely known and trusted corporate name. But if the entry barriers cannot be overcome readily, then the only feasible entry route may be through acquisition of a well-established com- pany. While entry barriers may also be overcome with a strong complementary joint venture, this mode is the more uncertain choice due to the lack of industry experience.
The Question of Speed Speed is another determining factor in deciding how to go about entering a new business. Acquisition is a favored mode of entry when speed is of the essence, as is the case in rapidly changing industries where fast mov-
ers can secure long-term positioning advantages. Speed is important in industries where early movers gain experience-based advantages that grow ever larger over time as they move down the learning curve. It is also important in technology- based industries where there is a race to establish an industry standard or leading technological platform. But in other cases it can be better to enter a market after the uncertainties about technology or consumer preferences have been resolved and learn from the missteps of early entrants. In these cases, joint venture or internal development may be preferred.
The Question of Comparative Cost The question of which mode of entry is most cost-effective is a critical one, given the need for a diversification strategy to pass the cost of entry test. Acquisition can be a high-cost mode of entry due to the need to pay a premium over the share price of the target company. When the premium is high, the price of the deal will exceed the worth of the acquired
CORE CONCEPT
Transaction costs are the costs of completing a business agreement or deal, over and above the price of the deal. They can include the costs of searching for an attractive target, the costs of evaluating its worth, bargaining costs, and the costs of completing the transaction.
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company as a stand-alone business by a substantial amount. Whether it is worth it to pay that high a price will depend on how much extra value will be created by the new combination of companies in the form of synergies. Moreover, the true cost of an acquisition must include the transaction costs of identifying and evaluating potential targets, negotiating a price, and completing other aspects of deal making. In addition, the true cost must take into account the costs of integrating the acquired company into the parent company’s portfolio of businesses.
Joint ventures may provide a way to conserve on such entry costs. But even here, there are organizational coordination costs and transaction costs that must be consid- ered, including settling on the terms of the arrangement. If the partnership doesn’t proceed smoothly and is not founded on trust, these costs may be significant.
CORE CONCEPT
Related businesses possess competitively valuable cross-business value chain and resource commonalities; unrelated businesses have dissimilar value chains and resource requirements, with no competitively important cross-business commonalities at the value chain level.
CHOOSING THE DIVERSIFICATION PATH: RELATED VERSUS UNRELATED BUSINESSES Once a company decides to diversify, it faces the choice of whether to diversify into related businesses, unrelated businesses, or some mix of both. Businesses are said to be related when their value chains exhibit competitively important cross-business commonalities. By this, we mean that there is a close correspon- dence between the businesses in terms of how they perform key value chain activ- ities and the resources and capabilities each needs to perform those activities. The big appeal of related diversification is the opportunity to build shareholder value by leveraging these cross-business commonalities into competitive advan- tages, thus allowing the company as a whole to perform better than just the sum of its individual businesses. Businesses are said to be unrelated when the resource requirements and key value chain activities are so dissimilar that no competitively important cross-business commonalities exist.
The next two sections explore the ins and outs of related and unrelated diversification.
A related diversification strategy involves building the company around businesses where there is good strategic fit across corresponding value chain activities. Strategic fit exists whenever one or more activities constituting the value chains of different busi- nesses are sufficiently similar to present opportunities for cross-business sharing or transferring of the resources and capabilities that enable these activities.8 Prime exam- ples of such opportunities include:
∙ Transferring specialized expertise, technological know-how, or other competi- tively valuable strategic assets from one business’s value chain to another’s. Google’s ability to transfer software developers and other information technol- ogy specialists from other business applications to the development of its Android mobile operating system and Chrome operating system for PCs aided consider- ably in the success of these new internal ventures.
∙ Sharing costs between businesses by combining their related value chain activi- ties into a single operation. For instance, it is often feasible to manufacture the
DIVERSIFICATION INTO RELATED BUSINESSES
LO 2
How related diversification strategies can produce cross- business strategic fit capable of delivering competitive advantage.
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products of different businesses in a single plant, use the same warehouses for shipping and distribution, or have a single sales force for the products of differ- ent businesses if they are marketed to the same types of customers.
∙ Exploiting the common use of a well-known brand name. For example, Yamaha’s name in motorcycles gave the company instant credibility and recognition in entering the personal-watercraft business, allowing it to achieve a significant market share without spending large sums on advertising to establish a brand identity for the WaveRunner. Likewise, Apple’s reputation for producing easy- to-operate computers was a competitive asset that facilitated the company’s diversification into digital music players, smartphones, and connected watches.
∙ Sharing other resources (besides brands) that support corresponding value chain activities across businesses. When Disney acquired Marvel Comics, management saw to it that Marvel’s iconic characters, such as Spiderman, Iron Man, and the Black Widow, were shared with many of the other Disney
CORE CONCEPT
Strategic fit exists whenever one or more activities constituting the value chains of different businesses are sufficiently similar to present opportunities for cross-business sharing or transferring of the resources and capabilities that enable these activities.
CORE CONCEPT
Related diversification involves sharing or transferring specialized resources and capabilities. Specialized resources and capabilities have very specific applications and their use is limited to a restricted range of industry and business types, in contrast to general resources and capabilities, which can be widely applied and can be deployed across a broad range of industry and business types.
businesses, including its theme parks, retail stores, motion picture division, and video game business. (Disney’s characters, starting with Mickey Mouse, have always been among the most valuable of its resources.) Automobile companies like Ford share resources such as their relationships with suppliers and dealer net- works across their lines of business.
∙ Engaging in cross-business collaboration and knowledge sharing to create new competitively valuable resources and capabilities. Businesses performing closely related value chain activities may seize opportunities to join forces, share knowl- edge and talents, and collaborate to create altogether new capabilities (such as virtually defect-free assembly methods or increased ability to speed new products to market) that will be mutually beneficial in improving their competitiveness and business performance.
Related diversification is based on value chain matchups with respect to key value chain activities—those that play a central role in each business’s strategy and that link to its industry’s key success factors. Such matchups facilitate the sharing or transfer of the resources and capabilities that enable the performance of these activities and
underlie each business’s quest for competitive advantage. By facilitating the shar- ing or transferring of such important competitive assets, related diversification can elevate each business’s prospects for competitive success.
The resources and capabilities that are leveraged in related diversification are specialized resources and capabilities. By this we mean that they have very specific applications; their use is restricted to a limited range of business contexts in which these applications are competitively relevant. Because they are adapted for particular applications, specialized resources and capabilities must be utilized by particular types of businesses operating in specific kinds of industries to have value; they have limited utility outside this designated range of industry and busi- ness applications. This is in contrast to general resources and capabilities (such as general management capabilities, human resource management capabilities, and general accounting services), which can be applied usefully across a wide range of industry and business types.
L’Oréal is the world’s largest beauty products company, with more than $30 billion in revenues and a successful strategy of related diversification built on leveraging a highly specialized set of resources and capabilities. These include 23 dermatologic and cosmetic research centers, R&D capabilities and scientific knowl- edge concerning skin and hair care, patents and secret formulas for hair and skin
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care products, and robotic applications developed specifically for testing the safety of hair and skin care products. These resources and capabilities are highly valuable for businesses focused on products for human skin and hair—they are specialized to such applications, and, in consequence, they are of little or no value beyond this restricted range of applications. To leverage these resources in a way that maximizes their potential value, L’Oréal has diversified into cosmetics, hair care products, skin care products, and fragrances (but not food, transportation, industrial services, or any application area far from the narrow domain in which its specialized resources are competitively relevant). L’Oréal’s businesses are related to one another on the basis of its value-generating specialized resources and capabilities and the cross-business link- ages among the value chain activities that they enable.
Corning’s most competitively valuable resources and capabilities are specialized to applications concerning fiber optics and specialty glass and ceramics. Over the course of its 150-year history, it has developed an unmatched understanding of fundamen- tal glass science and related technologies in the field of optics. Its capabilities now span a variety of sophisticated technologies and include expertise in domains such as custom glass composition, specialty glass melting and forming, precision optics, high-end transmissive coatings, and optomechanical materials. Corning has leveraged these specialized capabilities into a position of global leadership in five related market segments: display technologies based on glass substrates, environmental technologies using ceramic substrates and filters, optical fibers and cables for telecommunications, optical biosensors for drug discovery, and specialty materials employing advanced optics and specialty glass solutions. The market segments into which Corning has diversified are all related by their reliance on Corning’s specialized capability set and by the many value chain activities that they have in common as a result.
General Mills has diversified into a closely related set of food businesses on the basis of its capabilities in the realm of “kitchen chemistry” and food production tech- nologies. Its five U.S. retail divisions—meals, cereal, snacks, baking, and yogurt— include brands such as Old El Paso, Green Giant, Lucky Charms and General Mills brand cereals, Nature Valley, Annie’s Organic, Pillsbury and Betty Crocker, and Yoplait yogurt. Earlier it had diversified into restaurant businesses on the mistaken notion that all food businesses were related. By exiting these businesses in the mid- 1990s, the company was able to improve its overall profitability and strengthen its position in its remaining businesses. The lesson from its experience—and a takeaway for the managers of any diversified company—is that it is not product relatedness that defines a well-crafted related diversification strategy. Rather, the businesses must be related in terms of their key value chain activities and the specialized resources and capabilities that enable these activities.9 An example is Citizen Holdings Company, whose products appear to be different (watches, miniature card calculators, hand- held televisions) but are related in terms of their common reliance on miniaturization know-how and advanced precision technologies.
While companies pursuing related diversification strategies may also have oppor- tunities to share or transfer their general resources and capabilities (e.g., information systems; human resource management practices; accounting and tax services; bud- geting, planning, and financial reporting systems; expertise in legal and regulatory affairs; and fringe-benefit management systems), the most competitively valuable opportunities for resource sharing or transfer always come from leveraging their spe- cialized resources and capabilities. The reason for this is that specialized resources and capabilities drive the key value-creating activities that both connect the busi- nesses (at points along their value chains where there is strategic fit) and link to the
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key success factors in the markets where they are competitively relevant. Figure 8.1 illustrates the range of opportunities to share and/or transfer specialized resources and capabilities among the value chain activities of related businesses. It is important to recognize that even though general resources and capabilities may be shared by multiple business units, such resource sharing alone cannot form the backbone of a strategy keyed to related diversification.
Identifying Cross-Business Strategic Fit along the Value Chain Cross-business strategic fit can exist anywhere along the value chain—in R&D and technology activities, in supply chain activities and relationships with suppliers, in manufacturing, in sales and marketing, in distribution activities, or in customer ser- vice activities.10
Strategic Fit in Supply Chain Activities Businesses with strategic fit with respect to their supply chain activities can perform better together because of the potential for transferring skills in procuring materials, sharing resources and capabilities in logistics, collaborating with common supply chain partners, and/or
FIGURE 8.1 Related Businesses Provide Opportunities to Benefit from Competitively Valuable Strategic Fit
Representative Value Chain Activities
Business A
Business B
Support Activities
Support Activities
Supply Chain Activities
Sales and Marketing
Customer ServiceTechnology Operations Distribution
Supply Chain Activities
Sales and Marketing
Customer ServiceTechnology
Operations Distribution
Share or transfer valuable specialized resources and capabilities at one or more points along the value chains of business A and business B.
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increasing leverage with shippers in securing volume discounts on incoming parts and components. Dell Computer’s strategic partnerships with leading suppliers of micro- processors, circuit boards, disk drives, memory chips, flat-panel displays, wireless capabilities, long-life batteries, and other PC-related components have been an impor- tant element of the company’s strategy to diversify into servers, data storage devices, networking components, and LED TVs—products that include many components common to PCs and that can be sourced from the same strategic partners that provide Dell with PC components.
Strategic Fit in R&D and Technology Activities Businesses with strategic fit in R&D or technology development perform better together than apart because of potential cost savings in R&D, shorter times in getting new products to market, and more innovative products or processes. Moreover, technological advances in one business can lead to increased sales for both. Technological innovations have been the driver behind the efforts of cable TV companies to diversify into high-speed Internet access (via the use of cable modems) and, further, to explore providing local and long-distance telephone service to residential and commercial customers either through a single wire or by means of Voice over Internet Protocol (VoIP) technology. These diversification efforts have resulted in companies such as DISH, XFINITY, and Comcast now offering TV, Internet, and phone bundles.
Manufacturing-Related Strategic Fit Cross-business strategic fit in manufacturing-related activities can be exploited when a diversifier’s expertise in qual- ity control and cost-efficient production methods can be transferred to another busi- ness. When Emerson Electric diversified into the chain-saw business, it transferred its expertise in low-cost manufacture to its newly acquired Beaird-Poulan business divi- sion. The transfer drove Beaird-Poulan’s new strategy—to be the low-cost provider of chain-saw products—and fundamentally changed the way Beaird-Poulan chain saws were designed and manufactured. Another benefit of production-related value chain commonalities is the ability to consolidate production into a smaller number of plants and significantly reduce overall production costs. When snowmobile maker Bombar- dier diversified into motorcycles, it was able to set up motorcycle assembly lines in the manufacturing facility where it was assembling snowmobiles. When Smucker’s acquired Procter & Gamble’s Jif peanut butter business, it was able to combine the manufacture of the two brands of peanut butter products while gaining greater lever- age with vendors in purchasing its peanut supplies.
Strategic Fit in Sales and Marketing Activities Various cost- saving opportunities spring from diversifying into businesses with closely related sales and marketing activities. When the products are sold directly to the same custom- ers, sales costs can often be reduced by using a single sales force instead of having two different salespeople call on the same customer. The products of related busi- nesses can be promoted at the same website and included in the same media ads and sales brochures. There may be opportunities to reduce costs by consolidating order processing and billing and by using common promotional tie-ins. When global power toolmaker Black & Decker acquired Vector Products, it was able to use its own global sales force to sell the newly acquired Vector power inverters, vehicle battery chargers, and rechargeable spotlights because the types of customers that carried its power tools (discounters like Kmart, home centers, and hardware stores) also stocked the types of products produced by Vector.
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A second category of benefits arises when different businesses use similar sales and marketing approaches. In such cases, there may be competitively valuable opportuni- ties to transfer selling, merchandising, advertising, and product differentiation skills from one business to another. Procter & Gamble’s product lineup includes Pampers diapers, Olay beauty products, Tide laundry detergent, Crest toothpaste, Charmin toi- let tissue, Gillette razors and blades, Swiffer cleaning products, Oral-B toothbrushes, and Head & Shoulders shampoo. All of these have different competitors and different supply chain and production requirements, but they all move through the same whole- sale distribution systems, are sold in common retail settings to the same shoppers, and require the same marketing and merchandising skills.
Distribution-Related Strategic Fit Businesses with closely related dis- tribution activities can perform better together than apart because of potential cost savings in sharing the same distribution facilities or using many of the same wholesale distributors and retail dealers. When Conair Corporation acquired Allegro Manufac- turing’s travel bag and travel accessory business, it was able to consolidate its own distribution centers for hair dryers and curling irons with those of Allegro, thereby generating cost savings for both businesses. Likewise, since Conair products and Alle- gro’s neck rests, ear plugs, luggage tags, and toiletry kits were sold by the same types of retailers (discount stores, supermarket chains, and drugstore chains), Conair was able to convince many of the retailers not carrying Allegro products to take on the line.
Strategic Fit in Customer Service Activities Strategic fit with respect to customer service activities can enable cost savings or differentiation advan- tages, just as it does along other points of the value chain. For example, cost savings may come from consolidating after-sale service and repair organizations for the prod- ucts of closely related businesses into a single operation. Likewise, different busi- nesses can often use the same customer service infrastructure. For instance, an electric utility that diversifies into natural gas, water, appliance repair services, and home security services can use the same customer data network, the same call centers and local offices, the same billing and accounting systems, and the same customer service infrastructure to support all of its products and services. Through the transfer of best practices in customer service across a set of related businesses or through the sharing of resources such as proprietary information about customer preferences, a multibusi- ness company can also create a differentiation advantage through higher-quality cus- tomer service.
Strategic Fit, Economies of Scope, and Competitive Advantage What makes related diversification an attractive strategy is the opportunity to convert cross-business strategic fit into a competitive advantage over business rivals whose operations do not offer comparable strategic-fit benefits. The greater the relatedness among a diversified company’s businesses, the bigger a company’s window for con- verting strategic fit into competitive advantage via (1) transferring skills or knowledge, (2) combining related value chain activities to achieve lower costs, (3) leveraging the use of a well-respected brand name, (4) sharing other valuable resources, and (5) using cross-business collaboration and knowledge sharing to create new resources and capa- bilities and drive innovation.
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Strategic Fit and Economies of Scope Strategic fit in the value chain activities of a diversified corporation’s different businesses opens up opportu- nities for economies of scope—a concept distinct from economies of scale. Econo- mies of scale are cost savings that accrue directly from a larger-sized operation—for example, unit costs may be lower in a large plant than in a small plant. Economies of scope, however, stem directly from strategic fit along the value chains of related businesses, which in turn enables the businesses to share resources or to transfer them from business to business at low cost. Such economies are open only to firms engaged in related diversification, since they are the result of related businesses performing R&D together, transferring managers from one business to another, using common manufacturing or distribution facilities, sharing a common sales force or dealer network, using the same established brand name, and the like. The greater the cross-business economies associated with resource sharing and transfer, the greater the potential for a related diversification strategy to give a multibusiness enterprise a cost advantage over rivals.
From Strategic Fit to Competitive Advantage, Added Profit- ability, and Gains in Shareholder Value The cost advantage from economies of scope is due to the fact that resource sharing allows a multibusiness firm to spread resource costs across its businesses and to avoid the expense of having to acquire and maintain duplicate sets of resources—one for each business. But related diversified companies can benefit from strategic fit in other ways as well.
Sharing or transferring valuable specialized assets among the company’s busi- nesses can help each business perform its value chain activities more proficiently. This translates into competitive advantage for the businesses in one or two basic ways: (1) The businesses can contribute to greater efficiency and lower costs relative to their competitors, and/or (2) they can provide a basis for differentiation so that customers are willing to pay relatively more for the businesses’ goods and services. In either or both of these ways, a firm with a well-executed related diversification strategy can boost the chances of its businesses attaining a competitive advantage.
The competitive advantage potential that flows from the capture of strategic-fit benefits is what enables a company pursuing related diversification to achieve 1 + 1 = 3 financial performance and the hoped-for gains in shareholder value. The greater the relatedness among a diversified company’s businesses, the big- ger a company’s window for converting strategic fit into competitive advantage. The strategic and business logic is compelling: Capturing the benefits of strategic fit along the value chains of its related businesses gives a diversified company a clear path to achieving competitive advantage over undiversified competitors and competitors whose own diversification efforts don’t offer equivalent strategic-fit benefits.11 Such competitive advantage potential provides a company with a dependable basis for earning profits and a return on investment that exceeds what the company’s businesses could earn as stand-alone enterprises. Converting the competitive advantage potential into greater profitability is what fuels 1 + 1 = 3 gains in shareholder value—the necessary outcome for satisfying the better-off test and proving the business merit of a company’s diversification effort.
There are five things to bear in mind here:
1. Capturing cross-business strategic-fit benefits via a strategy of related diver- sification builds shareholder value in ways that shareholders cannot undertake by simply owning a portfolio of stocks of companies in different industries.
CORE CONCEPT
Economies of scope are cost reductions that flow from operating in multiple businesses (a larger scope of operation). This is in contrast to economies of scale, which accrue from a larger-sized operation.
Diversifying into related businesses where competitively valuable strategic-fit benefits can be captured puts a company’s businesses in position to perform better financially as part of the company than they could have performed as independent enterprises, thus providing a clear avenue for increasing shareholder value and satisfying the better-off test.
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2. The capture of cross-business strategic-fit benefits is possible only via a strategy of related diversification.
3. The greater the relatedness among a diversified company’s businesses, the bigger the company’s window for converting strategic fit into competitive advantage.
4. The benefits of cross-business strategic fit come from the transferring or shar- ing of competitively valuable resources and capabilities among the businesses— resources and capabilities that are specialized to certain applications and have value only in specific types of industries and businesses.
5. The benefits of cross-business strategic fit are not automatically realized when a company diversifies into related businesses; the benefits materialize only after management has successfully pursued internal actions to capture them.
Illustration Capsule 8.1 describes the merger of Kraft Foods Group, Inc. with the H. J. Heinz Holding Corporation, in pursuit of the strategic-fit benefits of a related diversification strategy.
DIVERSIFICATION INTO UNRELATED BUSINESSES Achieving cross-business strategic fit is not a motivation for unrelated diversification. Companies that pursue a strategy of unrelated diversification generally exhibit a will- ingness to diversify into any business in any industry where senior managers see an opportunity to realize consistently good financial results. Such companies are fre- quently labeled conglomerates because their business interests range broadly across diverse industries. Companies engaged in unrelated diversification nearly always enter new businesses by acquiring an established company rather than by forming a startup subsidiary within their own corporate structures or participating in joint ventures.
With a strategy of unrelated diversification, an acquisition is deemed to have potential if it passes the industry-attractiveness and cost of entry tests and if it has good prospects for attractive financial performance. Thus, with an unrelated diversifi- cation strategy, company managers spend much time and effort screening acquisition candidates and evaluating the pros and cons of keeping or divesting existing busi- nesses, using such criteria as:
∙ Whether the business can meet corporate targets for profitability and return on investment.
∙ Whether the business is in an industry with attractive growth potential. ∙ Whether the business is big enough to contribute significantly to the parent firm’s
bottom line.
But the key to successful unrelated diversification is to go beyond these consider- ations and ensure that the strategy passes the better-off test as well. This test requires more than just growth in revenues; it requires growth in profits—beyond what could be achieved by a mutual fund or a holding company that owns shares of the businesses without adding any value. Unless the combination of businesses is more profitable together under the corporate umbrella than they are apart as independent businesses, the strategy cannot create economic value for shareholders. And unless it does so, there is no real justification for unrelated diversification, since top executives have a fiduciary responsibility to maximize long-term shareholder value for the company’s owners (its shareholders).
LO 3
The merits and risks of unrelated diversification strategies.
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Building Shareholder Value via Unrelated Diversification Given the absence of cross-business strategic fit with which to create competitive advantages, building shareholder value via unrelated diversification ultimately hinges on the ability of the parent company to improve its businesses (and make the combina- tion better off ) via other means. Critical to this endeavor is the role that the parent com- pany plays as a corporate parent.12 To the extent that a company has strong parenting capabilities—capabilities that involve nurturing, guiding, grooming, and governing
ILLUSTRATION CAPSULE 8.1
The $62.6 billion merger between Kraft and Heinz that was finalized in the summer of 2015 created the third largest food and beverage company in North Amer- ica and the fifth largest in the world. It was a merger predicated on the idea that the strategic fit between these two companies was such that they could create more value as a combined enterprise than they could as two separate companies. As a combined enterprise, Kraft Heinz would be able to exploit its cross-business value chain activities and resource similarities to more efficiently produce, distribute, and sell profitable pro- cessed food products.
Kraft and Heinz products share many of the same raw materials (milk, sugar, salt, wheat, etc.), which allows the new company to leverage its increased bargaining power as a larger business to get better deals with suppli- ers, using strategic fit in supply chain activities to achieve lower input costs and greater inbound efficiencies. More- over, because both of these brands specialized in pre- packaged foods, there is ample manufacturing-related strategic fit in production processes and packaging technologies that allow the new company to trim and streamline manufacturing operations.
Their distribution-related strategic fit will allow for the complete integration of distribution channels and transportation networks, resulting in greater outbound efficiencies and a reduction in travel time for prod- ucts moving from factories to stores. The Kraft Heinz Company is currently looking to leverage Heinz’s global platform to expand Kraft’s products internationally. By utilizing Heinz’s already highly developed global distri- bution network and brand familiarity (key specialized resources), Kraft can more easily expand into the global
market of prepackaged and processed food. Because these two brands are sold at similar types of retail stores (supermarket chains, wholesale retailers, and local gro- cery stores), they are now able to claim even more shelf space with the increased bargaining power of the com- bined company.
Strategic fit in sales and marketing activities will allow the company to develop coordinated and more effective advertising campaigns. Toward this aim, the Kraft Heinz Company is moving to consolidate its mar- keting capabilities under one marketing firm. Also, by combining R&D teams, the Kraft Heinz Company could come out with innovative products that may appeal more to the growing number of on-the-go and health- conscious buyers in the market. Many of these potential and predicted synergies for the Kraft Heinz Company have yet to be realized, since merger integration activi- ties always take time.
The Kraft–Heinz Merger: Pursuing the Benefits of Cross-Business Strategic Fit
© Scott Olson/Getty Images
Note: Developed with Maria Hart.
Sources: w w w.forbes.com/sites/paulmartyn/2015/03/31/heinz-and-kraft-merger-makes-supply-management-sense/; fortune.com/2015/03/2 5/kraft- mess-how-heinz- deal-helps/; w w w.nytimes.com/2015/03/26/business/dealbook /kraft-and-heinz-to -merge.html?_ r=2; company websites (accessed December 3, 2015).
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constituent businesses—a corporate parent can propel its businesses forward and help them gain ground over their market rivals. Corporate parents also contribute to the competitiveness of their unrelated businesses by sharing or transferring general resources and capabilities across the businesses—competitive assets that have utility in any type of industry and that can be leveraged across a wide range of business types as a result. Examples of the kinds of general resources that a corporate parent lever- ages in unrelated diversification include the corporation’s reputation, credit rating, and access to financial markets; governance mechanisms; management training programs; a corporate ethics program; a central data and communications center; shared admin- istrative resources such as public relations and legal services; and common systems for functions such as budgeting, financial reporting, and quality control.
The Benefits of Astute Corporate Parenting One of the most important ways that corporate parents contribute to the success of their businesses is by offering high-level oversight and guidance.13 The top executives of a large diversi- fied corporation have among them many years of accumulated experience in a variety of business settings and can often contribute expert problem-solving skills, creative strategy suggestions, and first-rate advice and guidance on how to improve competi- tiveness and financial performance to the heads of the company’s various business subsidiaries. This is especially true in the case of newly acquired, smaller businesses. Particularly astute high-level guidance from corporate executives can help the subsid- iaries perform better than they would otherwise be able to do through the efforts of the business unit heads alone. The outstanding leadership of Royal Little, the founder of Textron, was a major reason that the company became an exemplar of the unre- lated diversification strategy while he was CEO. Little’s bold moves transformed the company from its origins as a small textile manufacturer into a global powerhouse
known for its Bell helicopters, Cessna aircraft, and a host of other strong brands in a wide array of industries. Norm Wesley, a former CEO of the conglomerate Fortune Brands, is similarly credited with driving the sharp rise in the company’s stock price while he was at the helm. Under his leadership, Fortune Brands became the $7 billion maker of products ranging from spirits (e.g., Jim Beam bourbon and rye, Gilbey’s gin and vodka, Courvoisier cognac) to golf products (e.g., Titleist golf balls and clubs, FootJoy golf shoes and apparel, Scotty Cameron putters) to hardware (e.g., Moen faucets, American Lock security devices). (Fortune Brands has since been converted into two separate entities, Beam Inc. and Fortune Brands Home & Security.)
Corporate parents can also create added value for their businesses by provid- ing them with other types of general resources that lower the operating costs of the individual businesses or that enhance their operating effectiveness. The administra- tive resources located at a company’s corporate headquarters are a prime example. They typically include legal services, accounting expertise and tax services, and other elements of the administrative infrastructure, such as risk management capa- bilities, information technology resources, and public relations capabilities. Provid- ing individual businesses with general support resources such as these creates value by lowering companywide overhead costs, since each business would otherwise have to duplicate the centralized activities.
Corporate brands that do not connote any specific type of product are another type of general corporate resource that can be shared among unrelated busi- nesses. General Electric, for example, has successfully applied its GE brand to such unrelated products and businesses as appliances (GE refrigerators, ovens, and
CORE CONCEPT
Corporate parenting refers to the role that a diversified corporation plays in nurturing its component businesses through the provision of top management expertise, disciplined control, financial resources, and other types of general resources and capabilities such as long- term planning systems, business development skills, management development processes, and incentive systems. The parenting activities of corporate executives often include recruiting and hiring talented managers to run individual businesses.
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washer-dryers), medical products and health care (GE Healthcare), jet engines (GE Aviation), and power and water optimization technologies (GE Power and Water). Corporate brands that are applied in this fashion are sometimes called umbrella brands. Utilizing a well-known corporate name (GE) in a diversified company’s individual businesses has the potential not only to lower costs (by spreading the fixed cost of developing and maintaining the brand over many businesses) but also to enhance each business’s customer value proposition by linking its products to a name that consumers trust. In similar fashion, a corporation’s reputation for well- crafted products, for product reliability, or for trustworthiness can lead to greater customer willingness to purchase the products of a wider range of a diversified company’s businesses. Incentive systems, financial control systems, and a company’s culture are other types of general corporate resources that may prove useful in enhanc- ing the daily operations of a diverse set of businesses.
We discuss two other commonly employed ways for corporate parents to add value to their unrelated businesses next.
Judicious Cross-Business Allocation of Financial Resources By reallocating surplus cash flows from some businesses to fund the capital require- ments of other businesses—in essence, having the company serve as an internal capi- tal market—corporate parents may also be able to create value. Such actions can be particularly important in times when credit is unusually tight (such as in the wake of the worldwide banking crisis that began in 2008) or in economies with less well devel- oped capital markets. Under these conditions, with strong financial resources a corpo- rate parent can add value by shifting funds from business units generating excess cash (more than they need to fund their own operating requirements and new capital invest- ment opportunities) to other, cash-short businesses with appealing growth prospects. A parent company’s ability to function as its own internal capital market enhances overall corporate performance and increases shareholder value to the extent that (1) its top managers have better access to information about investment opportunities internal to the firm than do external financiers or (2) it can provide funds that would otherwise be unavailable due to poor financial market conditions.
Acquiring and Restructuring Undervalued Companies Another way for parent companies to add value to unrelated businesses is by acquiring weakly performing companies at a bargain price and then restructuring their operations in ways that produce sometimes dramatic increases in profitability. Restructuring refers to overhauling and streamlining the operations of a business—combining plants with excess capacity, selling off underutilized assets, reducing unnecessary expenses, revamping its product offerings, consolidating administrative functions to reduce overhead costs, and otherwise improving the operating efficiency and profitability of a company. Restructuring generally involves transferring seasoned managers to the newly acquired business, either to replace the top layers of manage- ment or to step in temporarily until the business is returned to profitability or is well on its way to becoming a major market contender.
Restructuring is often undertaken when a diversified company acquires a new business that is performing well below levels that the corporate parent believes are achievable. Diversified companies that have proven turnaround capabilities in rejuvenating weakly performing companies can often apply these capabilities in a relatively wide range of unrelated industries. Newell Rubbermaid (whose diverse product line includes Sharpie pens, Levolor window treatments, Goody hair
An umbrella brand is a corporate brand name that can be applied to a wide assortment of business types. As such, it is a type of general resource that can be leveraged in unrelated diversification.
CORE CONCEPT
Restructuring refers to overhauling and streamlining the activities of a business—combining plants with excess capacity, selling off underutilized assets, reducing unnecessary expenses, and otherwise improving the productivity and profitability of a company.
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accessories, Calphalon cookware, and Lenox power and hand tools—all businesses with different value chain activities) developed such a strong set of turnaround capa- bilities that the company was said to “Newellize” the businesses it acquired.
Successful unrelated diversification strategies based on restructuring require the parent company to have considerable expertise in identifying underperforming tar- get companies and in negotiating attractive acquisition prices so that each acquisition passes the cost of entry test. The capabilities in this regard of Lord James Hanson and Lord Gordon White, who headed up the storied British conglomerate Hanson Trust, played a large part in Hanson Trust’s impressive record of profitability.
The Path to Greater Shareholder Value through Unrelated Diversification For a strategy of unrelated diversification to produce companywide financial results above and beyond what the businesses could generate operating as stand-alone enti- ties, corporate executives must do three things to pass the three tests of corporate advantage:
1. Diversify into industries where the businesses can produce consistently good earnings and returns on investment (to satisfy the industry-attractiveness test).
2. Negotiate favorable acquisition prices (to satisfy the cost of entry test). 3. Do a superior job of corporate parenting via high-level managerial oversight and
resource sharing, financial resource allocation and portfolio management, and/or the restructuring of underperforming businesses (to satisfy the better-off test).
The best corporate parents understand the nature and value of the kinds of resources at their command and know how to leverage them effectively across their businesses. Those that are able to create more value in their businesses than other diversified companies have what is called a parenting advantage. When a corpo- ration has a parenting advantage, its top executives have the best chance of being able to craft and execute an unrelated diversification strategy that can satisfy all three tests of corporate advantage and truly enhance long-term economic share- holder value.
The Drawbacks of Unrelated Diversification Unrelated diversification strategies have two important negatives that undercut the pluses: very demanding managerial requirements and limited competitive advan- tage potential.
Demanding Managerial Requirements Successfully managing a set of fundamentally different businesses operating in fundamentally different industry and competitive environments is a challenging and exceptionally difficult proposition.14 Consider, for example, that corporations like General Electric, ITT, Mitsubishi, and Bharti Enterprises have dozens of business subsidiaries making hundreds and some- times thousands of products. While headquarters executives can glean information about an industry from third-party sources, ask lots of questions when making occa- sional visits to the operations of the different businesses, and do their best to learn about the company’s different businesses, they still remain heavily dependent on brief- ings from business unit heads and on “managing by the numbers”—that is, keeping a
CORE CONCEPT
A diversified company has a parenting advantage when it is more able than other companies to boost the combined performance of its individual businesses through high-level guidance, general oversight, and other corporate-level contributions.
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close track on the financial and operating results of each subsidiary. Managing by the numbers works well enough when business conditions are normal and the heads of the various business units are capable of consistently meeting their numbers. But prob- lems arise if things start to go awry in a business and corporate management has to get deeply involved in the problems of a business it does not know much about. Because every business tends to encounter rough sledding at some juncture, unrelated diversi- fication is thus a somewhat risky strategy from a managerial perspective.15 Just one or two unforeseen problems or big strategic mistakes—which are much more likely without close corporate oversight—can cause a precipitous drop in corporate earnings and crash the parent company’s stock price.
Hence, competently overseeing a set of widely diverse businesses can turn out to be much harder than it sounds. In practice, comparatively few companies have proved that they have top-management capabilities that are up to the task. There are far more companies whose corporate executives have failed at delivering consistently good financial results with an unrelated diversification strategy than there are companies with corporate executives who have been successful.16 Unless a company truly has a parenting advantage, the odds are that the result of unrelated diversification will be 1 + 1 = 2 or even less.
Limited Competitive Advantage Potential The second big nega- tive is that unrelated diversification offers only a limited potential for competi- tive advantage beyond what each individual business can generate on its own. Unlike a related diversification strategy, unrelated diversification provides no cross-business strategic-fit benefits that allow each business to perform its key value chain activities in a more efficient and effective manner. A cash-rich cor- porate parent pursuing unrelated diversification can provide its subsidiaries with much-needed capital, may achieve economies of scope in activities relying on general corporate resources, and may even offer some managerial know-how to help resolve problems in particular business units, but otherwise it has little to offer in the way of enhancing the competitive strength of its individual business units. In comparison to the highly specialized resources that facilitate related diversification, the general resources that support unrelated diversification tend to be relatively low value, for the simple reason that they are more common. Unless they are of exceptionally high quality (such as GE’s world-renowned general man- agement capabilities or Newell Rubbermaid’s turnaround capabilities), resources and capabilities that are general in nature are less likely to provide a source of com- petitive advantage for diversified companies. Without the competitive advantage potential of strategic fit in competitively important value chain activities, consoli- dated performance of an unrelated group of businesses stands to be little more than the sum of what the individual business units could achieve if they were indepen- dent, in most circumstances.
Misguided Reasons for Pursuing Unrelated Diversification Companies sometimes pursue unrelated diversification for reasons that are misguided. These include the following:
∙ Risk reduction. Spreading the company’s investments over a set of diverse indus- tries to spread risk cannot create long-term shareholder value since the company’s
Relying solely on leveraging general resources and the expertise of corporate executives to wisely manage a set of unrelated businesses is a much weaker foundation for enhancing shareholder value than is a strategy of related diversification.
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shareholders can more flexibly (and more efficiently) reduce their exposure to risk by investing in a diversified portfolio of stocks and bonds.
∙ Growth. While unrelated diversification may enable a company to achieve rapid or continuous growth, firms that pursue growth for growth’s sake are unlikely to maximize shareholder value. Only profitable growth—the kind that comes from creating added value for shareholders—can justify a strategy of unrelated diversification.
∙ Stabilization. Managers sometimes pursue broad diversification in the hope that market downtrends in some of the company’s businesses will be partially offset by cyclical upswings in its other businesses, thus producing somewhat less earn- ings volatility. In actual practice, however, there’s no convincing evidence that the consolidated profits of firms with unrelated diversification strategies are more stable or less subject to reversal in periods of recession and economic stress than the profits of firms with related diversification strategies.
∙ Managerial motives. Unrelated diversification can provide benefits to managers such as higher compensation (which tends to increase with firm size and degree of diversification) and reduced unemployment risk. Pursuing diversification for these reasons will likely reduce shareholder value and violate managers’ fiduciary responsibilities.
Because unrelated diversification strategies at their best have only a limited potential for creating long-term economic value for shareholders, it is essential that managers not compound this problem by taking a misguided approach toward unrelated diversification, in pursuit of objectives that are more likely to destroy shareholder value than create it.
Only profitable growth— the kind that comes from creating added value for shareholders—can justify a strategy of unrelated diversification.
COMBINATION RELATED–UNRELATED DIVERSIFICATION STRATEGIES
There’s nothing to preclude a company from diversifying into both related and unrelated businesses. Indeed, in actual practice the business makeup of diversified companies varies considerably. Some diversified companies are really dominant- business enterprises—one major “core” business accounts for 50 to 80 percent of total revenues and a collection of small related or unrelated businesses accounts for the remainder. Some diversified companies are narrowly diversified around a few (two to five) related or unrelated businesses. Others are broadly diversified around a wide-ranging collection of related businesses, unrelated businesses, or a mixture of both. A number of multibusiness enterprises have diversified into unrelated areas but have a collection of related businesses within each area—thus giving them a busi- ness portfolio consisting of several unrelated groups of related businesses. There’s ample room for companies to customize their diversification strategies to incorpo- rate elements of both related and unrelated diversification, as may suit their own competitive asset profile and strategic vision. Combination related– unrelated diver- sification strategies have particular appeal for companies with a mix of valuable competitive assets, covering the spectrum from general to specialized resources and capabilities.
Figure 8.2 shows the range of alternatives for companies pursuing diversification.
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FIGURE 8.2 Three Strategy Options for Pursuing Diversification
Diversify into Related Businesses
Diversification Strategy Options
Diversify into Both Related and Unrelated
Businesses
Diversify into Unrelated Businesses
Strategic analysis of diversified companies builds on the concepts and methods used for single-business companies. But there are some additional aspects to consider and a couple of new analytic tools to master. The procedure for evaluating the pluses and minuses of a diversified company’s strategy and deciding what actions to take to improve the company’s performance involves six steps:
1. Assessing the attractiveness of the industries the company has diversified into, both individually and as a group.
2. Assessing the competitive strength of the company’s business units and drawing a nine-cell matrix to simultaneously portray industry attractiveness and business unit competitive strength.
3. Evaluating the extent of cross-business strategic fit along the value chains of the company’s various business units.
4. Checking whether the firm’s resources fit the requirements of its present business lineup.
5. Ranking the performance prospects of the businesses from best to worst and deter- mining what the corporate parent’s priorities should be in allocating resources to its various businesses.
6. Crafting new strategic moves to improve overall corporate performance.
EVALUATING THE STRATEGY OF A DIVERSIFIED COMPANY
LO 4
The analytic tools for evaluating a company’s diversification strategy.
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The core concepts and analytic techniques underlying each of these steps merit further discussion.
Step 1: Evaluating Industry Attractiveness A principal consideration in evaluating the caliber of a diversified company’s strategy is the attractiveness of the industries in which it has business operations. Several ques- tions arise:
1. Does each industry the company has diversified into represent a good market for the company to be in—does it pass the industry-attractiveness test?
2. Which of the company’s industries are most attractive, and which are least attractive? 3. How appealing is the whole group of industries in which the company has invested?
The more attractive the industries (both individually and as a group) that a diversi- fied company is in, the better its prospects for good long-term performance.
Calculating Industry-Attractiveness Scores A simple and reli- able analytic tool for gauging industry attractiveness involves calculating quantitative industry-attractiveness scores based on the following measures:
∙ Market size and projected growth rate. Big industries are more attractive than small industries, and fast-growing industries tend to be more attractive than slow- growing industries, other things being equal.
∙ The intensity of competition. Industries where competitive pressures are relatively weak are more attractive than industries where competitive pressures are strong.
∙ Emerging opportunities and threats. Industries with promising opportunities and minimal threats on the near horizon are more attractive than industries with mod- est opportunities and imposing threats.
∙ The presence of cross-industry strategic fit. The more one industry’s value chain and resource requirements match up well with the value chain activities of other industries in which the company has operations, the more attractive the industry is to a firm pursuing related diversification. However, cross-industry strategic fit is not something that a company committed to a strategy of unrelated diversification considers when it is evaluating industry attractiveness.
∙ Resource requirements. Industries in which resource requirements are within the company’s reach are more attractive than industries in which capital and other resource requirements could strain corporate financial resources and organiza- tional capabilities.
∙ Social, political, regulatory, and environmental factors. Industries that have sig- nificant problems in such areas as consumer health, safety, or environmental pol- lution or those subject to intense regulation are less attractive than industries that do not have such problems.
∙ Industry profitability. Industries with healthy profit margins and high rates of return on investment are generally more attractive than industries with historically low or unstable profits.
Each attractiveness measure is then assigned a weight reflecting its relative impor- tance in determining an industry’s attractiveness, since not all attractiveness mea- sures are equally important. The intensity of competition in an industry should nearly
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always carry a high weight (say, 0.20 to 0.30). Strategic-fit considerations should be assigned a high weight in the case of companies with related diversification strategies; but for companies with an unrelated diversification strategy, strategic fit with other industries may be dropped from the list of attractiveness measures altogether. The importance weights must add up to 1.
Finally, each industry is rated on each of the chosen industry-attractiveness mea- sures, using a rating scale of 1 to 10 (where a high rating signifies high attractive- ness, and a low rating signifies low attractiveness). Keep in mind here that the more intensely competitive an industry is, the lower the attractiveness rating for that industry. Likewise, the more the resource requirements associated with being in a particular industry are beyond the parent company’s reach, the lower the attrac- tiveness rating. On the other hand, the presence of good cross-industry strategic fit should be given a very high attractiveness rating, since there is good potential for competitive advantage and added shareholder value. Weighted attractiveness scores are then calculated by multiplying the industry’s rating on each measure by the corresponding weight. For example, a rating of 8 times a weight of 0.25 gives a weighted attractiveness score of 2. The sum of the weighted scores for all the attrac- tiveness measures provides an overall industry-attractiveness score. This procedure is illustrated in Table 8.1.
Interpreting the Industry-Attractiveness Scores Industries with a score much below 5 probably do not pass the attractiveness test. If a company’s industry-attractiveness scores are all above 5, it is probably fair to conclude that the group of industries the company operates in is attractive as a whole. But the group of industries takes on a decidedly lower degree of attractiveness as the number of indus- tries with scores below 5 increases, especially if industries with low scores account for a sizable fraction of the company’s revenues.
For a diversified company to be a strong performer, a substantial portion of its revenues and profits must come from business units with relatively high attrac- tiveness scores. It is particularly important that a diversified company’s principal businesses be in industries with a good outlook for growth and above-average prof- itability. Having a big fraction of the company’s revenues and profits come from industries with slow growth, low profitability, intense competition, or other trou- bling conditions tends to drag overall company performance down. Business units in the least attractive industries are potential candidates for divestiture, unless they are positioned strongly enough to overcome the unattractive aspects of their indus- try environments or they are a strategically important component of the company’s business makeup.
Step 2: Evaluating Business Unit Competitive Strength The second step in evaluating a diversified company is to appraise the competitive strength of each business unit in its respective industry. Doing an appraisal of each business unit’s strength and competitive position in its industry not only reveals its chances for success in its industry but also provides a basis for ranking the units from competitively strongest to competitively weakest and sizing up the competitive strength of all the business units as a group.
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Calculating Competitive-Strength Scores for Each Business Unit Quantitative measures of each business unit’s competitive strength can be cal- culated using a procedure similar to that for measuring industry attractiveness. The following factors are used in quantifying the competitive strengths of a diversified company’s business subsidiaries:
∙ Relative market share. A business unit’s relative market share is defined as the ratio of its market share to the market share held by the largest rival firm in the industry, with market share measured in unit volume, not dollars. For instance, if business A has a market-leading share of 40 percent and its largest rival has 30 percent, A’s relative market share is 1.33. (Note that only business units that are market share leaders in their respective industries can have relative market shares
Industry-Attractiveness Assessments
Industry- Attractiveness Measure
Industry A Industry B Industry C
Importance Weight
Attractiveness Rating*
Weighted Score
Attractiveness Rating*
Weighted Score
Attractiveness Rating*
Weighted Score
Market size and projected growth rate
0.10 8 0.80 3 0.30 5 0.50
Intensity of competition
0.25 8 2.00 2 0.50 5 1.25
Emerging opportunities and threats
0.10 6 0.60 5 0.50 4 0.40
Cross-industry strategic fit
0.30 8 2.40 2 0.60 3 0.90
Resource requirements
0.10 5 0.50 5 0.50 4 0.40
Social, political, regulatory, and environmental factors
0.05 8 0.40 3 0.15 7 1.05
Industry profitability
0.10 5 0.50 4 0.40 6 0.60
Sum of importance weights
1.00
Weighted overall industry- attractiveness scores
7.20 2.95 5.10
*Rating scale: 1 = very unattractive to company; 10 = very attractive to company.
TABLE 8.1 Calculating Weighted Industry-Attractiveness Scores
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greater than 1.) If business B has a 15 percent market share and B’s largest rival has 30 percent, B’s relative market share is 0.5. The further below 1 a business unit’s relative market share is, the weaker its competitive strength and market position vis-à-vis rivals.
∙ Costs relative to competitors’ costs. Business units that have low costs relative to those of key competitors tend to be more strongly positioned in their indus- tries than business units struggling to maintain cost parity with major rivals. The only time a business unit’s competitive strength may not be undermined by having higher costs than rivals is when it has incurred the higher costs to strongly differ- entiate its product offering and its customers are willing to pay premium prices for the differentiating features.
∙ Ability to match or beat rivals on key product attributes. A company’s competi- tiveness depends in part on being able to satisfy buyer expectations with regard to features, product performance, reliability, service, and other important attributes.
∙ Brand image and reputation. A widely known and respected brand name is a valu- able competitive asset in most industries.
∙ Other competitively valuable resources and capabilities. Valuable resources and capabilities, including those accessed through collaborative partnerships, enhance a company’s ability to compete successfully and perhaps contend for industry leadership.
∙ Ability to benefit from strategic fit with other business units. Strategic fit with other businesses within the company enhances a business unit’s competitive strength and may provide a competitive edge.
∙ Ability to exercise bargaining leverage with key suppliers or customers. Having bargaining leverage signals competitive strength and can be a source of competi- tive advantage.
∙ Profitability relative to competitors. Above-average profitability on a consistent basis is a signal of competitive advantage, whereas consistently below-average profitability usually denotes competitive disadvantage.
After settling on a set of competitive-strength measures that are well matched to the circumstances of the various business units, the company needs to assign weights indicating each measure’s importance. As in the assignment of weights to industry-attractiveness measures, the importance weights must add up to 1. Each busi- ness unit is then rated on each of the chosen strength measures, using a rating scale of 1 to 10 (where a high rating signifies competitive strength, and a low rating signifies competitive weakness). In the event that the available information is too limited to confidently assign a rating value to a business unit on a particular strength measure, it is usually best to use a score of 5—this avoids biasing the overall score either up or down. Weighted strength ratings are calculated by multiplying the business unit’s rat- ing on each strength measure by the assigned weight. For example, a strength score of 6 times a weight of 0.15 gives a weighted strength rating of 0.90. The sum of the weighted ratings across all the strength measures provides a quantitative measure of a business unit’s overall competitive strength. Table 8.2 provides sample calculations of competitive-strength ratings for three businesses.
Interpreting the Competitive-Strength Scores Business units with competitive-strength ratings above 6.7 (on a scale of 1 to 10) are strong market contenders in their industries. Businesses with ratings in the 3.3-to-6.7 range have
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moderate competitive strength vis-à-vis rivals. Businesses with ratings below 3.3 have a competitively weak standing in the marketplace. If a diversified company’s business units all have competitive-strength scores above 5, it is fair to conclude that its busi- ness units are all fairly strong market contenders in their respective industries. But as the number of business units with scores below 5 increases, there’s reason to question whether the company can perform well with so many businesses in relatively weak competitive positions. This concern takes on even more importance when business units with low scores account for a sizable fraction of the company’s revenues.
Using a Nine-Cell Matrix to Simultaneously Portray Industry Attractiveness and Competitive Strength The industry-attractiveness and business-strength scores can be used to portray the strategic positions of each business in a diversified company. Industry attractiveness is plotted on the vertical axis and competitive strength on the horizontal axis. A nine-cell grid emerges from
Competitive-Strength Assessments
Business A in Industry A
Business B in Industry B
Business C in Industry C
Competitive-Strength Measures
Importance Weight
Strength Rating*
Weighted Score
Strength Rating*
Weighted Score
Strength Rating*
Weighted Score
Relative market share 0.15 10 1.50 2 0.30 6 0.90
Costs relative to competitors’ costs
0.20 7 1.40 4 0.80 5 1.00
Ability to match or beat rivals on key product attributes
0.05 9 0.45 5 0.25 8 0.40
Ability to benefit from strategic fit with sister businesses
0.20 8 1.60 4 0.80 8 0.80
Bargaining leverage with suppliers/customers
0.05 9 0.45 2 0.10 6 0.30
Brand image and reputation
0.10 9 0.90 4 0.40 7 0.70
Other valuable resources/ capabilities
0.15 7 1.05 2 0.30 5 0.75
Profitability relative to competitors
0.10 5 0.50 2 0.20 4 0.40
Sum of importance weights 1.00
Weighted overall competitive strength scores
7.85 3.15 5.25
*Rating scale: 1 = very weak; 10 = very strong.
TABLE 8.2 Calculating Weighted Competitive-Strength Scores for a Diversified Company’s Business Units
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FIGURE 8. 3 A Nine-Cell Industry-Attractiveness–Competitive-Strength Matrix
Competitive Strength/Market Position
In d
u st
ry A
tt ra
ct iv
e n
e ss
High
Medium
Low
Strong Average Weak
7.85 5.25
3.36.7
3.3
6.7
7.20
5.10
2.95
3.15
High priority for resource allocation Medium priority for resource allocation
Low priority for resource allocation
Business A in
industry A
Business C in
industry C
Note: Circle sizes are scaled to reflect the percentage of companywide revenues generated by the business unit.
Business B in
industry B
dividing the vertical axis into three regions (high, medium, and low attractiveness) and the horizontal axis into three regions (strong, average, and weak competitive strength). As shown in Figure 8.3, scores of 6.7 or greater on a rating scale of 1 to 10 denote high industry attractiveness, scores of 3.3 to 6.7 denote medium attractiveness, and scores below 3.3 signal low attractiveness. Likewise, high competitive strength is defined as scores greater than 6.7, average strength as scores of 3.3 to 6.7, and low strength as scores below 3.3. Each business unit is plotted on the nine-cell matrix according to its
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overall attractiveness score and strength score, and then it is shown as a “bubble.” The size of each bubble is scaled to the percentage of revenues the business generates relative to total corporate revenues. The bubbles in Figure 8.3 were located on the grid using the three industry-attractiveness scores from Table 8.1 and the strength scores for the three business units in Table 8.2.
The locations of the business units on the attractiveness–strength matrix provide valuable guidance in deploying corporate resources. Businesses positioned in the three cells in the upper left portion of the attractiveness–strength matrix (like business A) have both favorable industry attractiveness and competitive strength.
Next in priority come businesses positioned in the three diagonal cells stretching from the lower left to the upper right (like business C). Such businesses usually merit intermediate priority in the parent’s resource allocation ranking. However, some busi- nesses in the medium-priority diagonal cells may have brighter or dimmer prospects than others. For example, a small business in the upper right cell of the matrix, despite being in a highly attractive industry, may occupy too weak a competitive position in its industry to justify the investment and resources needed to turn it into a strong market contender.
Businesses in the three cells in the lower right corner of the matrix (like business B) have comparatively low industry attractiveness and minimal competitive strength, making them weak performers with little potential for improvement. At best, they have the lowest claim on corporate resources and may be good candidates for being divested (sold to other companies). However, there are occasions when a business located in the three lower-right cells generates sizable positive cash flows. It may make sense to retain such businesses and divert their cash flows to finance expansion of business units with greater potential for profit growth.
The nine-cell attractiveness–strength matrix provides clear, strong logic for why a diversified company needs to consider both industry attractiveness and business strength in allocating resources and investment capital to its different businesses. A good case can be made for concentrating resources in those businesses that enjoy higher degrees of attractiveness and competitive strength, being very selective in mak- ing investments in businesses with intermediate positions on the grid, and withdraw- ing resources from businesses that are lower in attractiveness and strength unless they offer exceptional profit or cash flow potential.
Step 3: Determining the Competitive Value of Strategic Fit in Diversified Companies While this step can be bypassed for diversified companies whose businesses are all unrelated (since, by design, strategic fit is lacking), assessing the degree of strategic fit across a company’s businesses is central to evaluating its related diversification strategy. But more than just checking for the presence of strategic fit is required here.
The real question is how much competitive value can be generated from whatever strategic fit exists. Are the cost savings associated with economies of scope likely to give one or more individual businesses a cost-based advantage over rivals? How much competitive value will come from the cross-business transfer of skills, tech- nology, or intellectual capital or the sharing of competitive assets? Can leveraging a potent umbrella brand or corporate image strengthen the businesses and increase sales significantly? Could cross-business collaboration to create new competitive capabilities lead to significant gains in performance? Without significant cross- business strategic fit and dedicated company efforts to capture the benefits, one has to be skeptical about the potential for a diversified company’s businesses to perform better together than apart.
The greater the value of cross-business strategic fit in enhancing the performance of a diversified company’s businesses, the more competitively powerful is the company’s related diversification strategy.
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Figure 8.4 illustrates the process of comparing the value chains of a company’s businesses and identifying opportunities to exploit competitively valuable cross- business strategic fit.
Step 4: Checking for Good Resource Fit The businesses in a diversified company’s lineup need to exhibit good resource fit. In firms with a related diversification strategy, good resource fit exists when the firm’s businesses have well-matched specialized resource requirements at points along their value chains that are critical for the businesses’ market success. Matching resource requirements are important in related diversification because they facilitate resource sharing and low-cost resource transfer. In companies pursuing unrelated diversification, resource fit exists when the company has solid parenting capabil- ities or resources of a general nature that it can share or transfer to its compo- nent businesses. Firms pursuing related diversification and firms with combination related–unrelated diversification strategies can also benefit from leveraging corporate parenting capabilities and other general resources. Another dimension of resource fit that concerns all types of multibusiness firms is whether they have resources sufficient to support their group of businesses without being spread too thin.
CORE CONCEPT
A company pursuing related diversification exhibits resource fit when its businesses have matching specialized resource requirements along their value chains; a company pursuing unrelated diversification has resource fit when the parent company has adequate corporate resources (parenting and general resources) to support its businesses’ needs and add value.
FIGURE 8.4 Identifying the Competitive Advantage Potential of Cross-Business Strategic Fit
Business A
Business B
Business C
Business D
Business E
Purchases from
Suppliers Technology Operations Sales and Marketing Distribution Service
Value Chain Activities
Opportunity to combine purchasing activities and gain more leverage with suppliers and realize supply chain economics
Opportunity to share technology, transfer technical skills, combine R&D
Opportunity to combine sales and marketing activities, use common distribution channels, leverage use of a common brand name, and/or combine after-sale service activities
Collaboration to create new competitive capabilities
No strategic-fit opportunities
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Financial Resource Fit The most important dimension of financial resource fit concerns whether a diversified company can generate the internal cash flows sufficient to fund the capital requirements of its businesses, pay its dividends, meet its debt obligations, and otherwise remain financially healthy. (Financial resources, including the firm’s ability to borrow or otherwise raise funds, are a type of general resource.) While additional capital can usually be raised in financial mar- kets, it is important for a diversified firm to have a healthy internal capital market that can support the financial requirements of its business lineup. The greater the extent to which a diversified company is able to fund investment in its businesses through internally generated cash flows rather than from equity issues or borrow- ing, the more powerful its financial resource fit and the less dependent the firm is on external financial resources. This can provide a competitive advantage over single business rivals when credit market conditions are tight, as they have been in the United States and abroad in recent years.
A portfolio approach to ensuring financial fit among a firm’s businesses is based on the fact that different businesses have different cash flow and invest- ment characteristics. For example, business units in rapidly growing industries are often cash hogs—so labeled because the cash flows they are able to generate from internal operations aren’t big enough to fund their operations and capital require- ments for growth. To keep pace with rising buyer demand, rapid-growth businesses frequently need sizable annual capital investments—for new facilities and equip- ment, for new product development or technology improvements, and for additional working capital to support inventory expansion and a larger base of operations. Because a cash hog’s financial resources must be provided by the corporate parent, corporate managers have to decide whether it makes good financial and strategic sense to keep pouring new money into a cash hog business.
In contrast, business units with leading market positions in mature industries may be cash cows in the sense that they generate substantial cash surpluses over what is needed to adequately fund their operations. Market leaders in slow-growth industries often generate sizable positive cash flows over and above what is needed for growth and reinvestment because their industry-leading positions tend to generate attractive earnings and because the slow-growth nature of their industry often entails relatively modest annual investment requirements. Cash cows, although not attractive from a growth standpoint, are valuable businesses from a financial resource perspective. The surplus cash flows they generate can be used to pay corporate dividends, finance acquisitions, and provide funds for investing in the company’s promising cash hogs. It makes good financial and strategic sense for diversified companies to keep cash cows in a healthy condition, fortifying and defending their market position so as to preserve their cash-generating capability and have an ongoing source of financial resources to deploy elsewhere. General Electric considers its advanced materials, equipment ser- vices, and appliance and lighting businesses to be cash cow businesses.
Viewing a diversified group of businesses as a collection of cash flows and cash requirements (present and future flows) can be helpful in understanding what the financial ramifications of diversification are and why having businesses with good financial resource fit can be important. For instance, a diversified company’s businesses exhibit good financial resource fit when the excess cash generated by its cash cow businesses is sufficient to fund the investment requirements of prom-
ising cash hog businesses. Ideally, investing in promising cash hog businesses over time results in growing the hogs into self-supporting star businesses that have strong or market-leading competitive positions in attractive, high-growth markets and high
CORE CONCEPT
A strong internal capital market allows a diversified company to add value by shifting capital from business units generating free cash flow to those needing additional capital to expand and realize their growth potential.
CORE CONCEPT
A portfolio approach to ensuring financial fit among a firm’s businesses is based on the fact that different businesses have different cash flow and investment characteristics.
CORE CONCEPT
A cash hog business generates cash flows that are too small to fully fund its growth; it thereby requires cash infusions to provide additional working capital and finance new capital investment.
CORE CONCEPT
A cash cow business generates cash flows over and above its internal requirements, thus providing a corporate parent with funds for investing in cash hog businesses, financing new acquisitions, or paying dividends.
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levels of profitability. Star businesses are often the cash cows of the future. When the markets of star businesses begin to mature and their growth slows, their competi- tive strength should produce self-generated cash flows that are more than sufficient to cover their investment needs. The “success sequence” is thus cash hog to young star (but perhaps still a cash hog) to self-supporting star to cash cow. While the practice of viewing a diversified company in terms of cash cows and cash hogs has declined in popularity, it illustrates one approach to analyzing financial resource fit and allocating financial resources across a portfolio of different businesses.
Aside from cash flow considerations, there are two other factors to consider in assessing whether a diversified company’s businesses exhibit good financial fit:
∙ Do any of the company’s individual businesses present financial challenges with respect to contributing adequately to achieving companywide performance tar- gets? A business exhibits poor financial fit if it soaks up a disproportionate share of the company’s financial resources, while making subpar or insignificant con- tributions to the bottom line. Too many underperforming businesses reduce the company’s overall performance and ultimately limit growth in shareholder value.
∙ Does the corporation have adequate financial strength to fund its different busi- nesses and maintain a healthy credit rating? A diversified company’s strategy fails the resource-fit test when the resource needs of its portfolio unduly stretch the company’s financial health and threaten to impair its credit rating. Many of the world’s largest banks, including Royal Bank of Scotland, Citigroup, and HSBC, recently found themselves so undercapitalized and financially overextended that they were forced to sell off some of their business assets to meet regulatory requirements and restore public confidence in their solvency.
Nonfinancial Resource Fit Just as a diversified company must have ade- quate financial resources to support its various individual businesses, it must also have a big enough and deep enough pool of managerial, administrative, and other parenting capabilities to support all of its different businesses. The following two questions help reveal whether a diversified company has sufficient nonfinancial resources:
∙ Does the parent company have (or can it develop) the specific resources and capa- bilities needed to be successful in each of its businesses? Sometimes the resources a company has accumulated in its core business prove to be a poor match with the competitive capabilities needed to succeed in the businesses into which it has diver- sified. For instance, BTR, a multibusiness company in Great Britain, discovered that the company’s resources and managerial skills were quite well suited for par- enting its industrial manufacturing businesses but not for parenting its distribution businesses (National Tyre Services and Texas-based Summers Group). As a result, BTR decided to divest its distribution businesses and focus exclusively on diver- sifying around small industrial manufacturing. For companies pursuing related diversification strategies, a mismatch between the company’s competitive assets and the key success factors of an industry can be serious enough to warrant divest- ing businesses in that industry or not acquiring a new business. In contrast, when a company’s resources and capabilities are a good match with the key success factors of industries it is not presently in, it makes sense to take a hard look at acquiring companies in these industries and expanding the company’s business lineup.
∙ Are the parent company’s resources being stretched too thinly by the resource requirements of one or more of its businesses? A diversified company must guard
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against overtaxing its resources and capabilities, a condition that can arise when (1) it goes on an acquisition spree and management is called on to assimilate and oversee many new businesses very quickly or (2) it lacks sufficient resource depth to do a creditable job of transferring skills and competencies from one of its busi- nesses to another. The broader the diversification, the greater the concern about whether corporate executives are overburdened by the demands of competently parenting so many different businesses. Plus, the more a company’s diversifica- tion strategy is tied to transferring know-how or technologies from existing busi- nesses to newly acquired businesses, the more time and money that has to be put into developing a deep-enough resource pool to supply these businesses with the resources and capabilities they need to be successful.17 Otherwise, its resource pool ends up being spread too thinly across many businesses, and the opportunity for achieving 1 + 1 = 3 outcomes slips through the cracks.
Step 5: Ranking Business Units and Assigning a Priority for Resource Allocation Once a diversified company’s strategy has been evaluated from the perspective of industry attractiveness, competitive strength, strategic fit, and resource fit, the next step is to use this information to rank the performance prospects of the businesses from best to worst. Such ranking helps top-level executives assign each business a priority for resource support and capital investment.
The locations of the different businesses in the nine-cell industry-attractiveness– competitive-strength matrix provide a solid basis for identifying high- opportunity businesses and low-opportunity businesses. Normally, competitively strong busi- nesses in attractive industries have significantly better performance prospects than competitively weak businesses in unattractive industries. Also, the revenue and earnings outlook for businesses in fast-growing industries is normally better than for businesses in slow-growing industries. As a rule, business subsidiaries with the brightest profit and growth prospects, attractive positions in the nine-cell matrix, and solid strategic and resource fit should receive top priority for allocation of corporate resources. However, in ranking the prospects of the different businesses from best to worst, it is usually wise to also take into account each business’s past performance in regard to sales growth, profit growth, contribution to company earnings, return on capital invested in the business, and cash flow from operations. While past performance is not always a reliable predictor of future performance, it does signal whether a business is already performing well or has problems to overcome.
Allocating Financial Resources Figure 8.5 shows the chief strategic and financial options for allocating a diversified company’s financial resources. Divesting businesses with the weakest future prospects and businesses that lack adequate stra- tegic fit and/or resource fit is one of the best ways of generating additional funds for redeployment to businesses with better opportunities and better strategic and resource fit. Free cash flows from cash cow businesses also add to the pool of funds that can be usefully redeployed. Ideally, a diversified company will have sufficient financial resources to strengthen or grow its existing businesses, make any new acquisitions that are desirable, fund other promising business opportunities, pay off existing debt, and periodically increase dividend payments to shareholders and/or repurchase shares of
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stock. But, as a practical matter, a company’s financial resources are limited. Thus, to make the best use of the available funds, top executives must steer resources to those businesses with the best prospects and either divest or allocate minimal resources to businesses with marginal prospects—this is why ranking the performance prospects of the various businesses from best to worst is so crucial. Strategic uses of corporate financial resources should usually take precedence over strictly financial consider- ations (see Figure 8.5) unless there is a compelling reason to strengthen the firm’s balance sheet or better reward shareholders.
Step 6: Crafting New Strategic Moves to Improve Overall Corporate Performance The conclusions flowing from the five preceding analytic steps set the agenda for crafting strategic moves to improve a diversified company’s overall performance. The strategic options boil down to four broad categories of actions (see Figure 8.6):
1. Sticking closely with the existing business lineup and pursuing the opportunities these businesses present.
2. Broadening the company’s business scope by making new acquisitions in new industries.
3. Divesting certain businesses and retrenching to a narrower base of business operations.
4. Restructuring the company’s business lineup and putting a whole new face on the company’s business makeup.
LO 5
What four main corporate strategy options a diversified company can employ for solidifying its strategy and improving company performance.
FIGURE 8.5 The Chief Strategic and Financial Options for Allocating a Diversified Company’s Financial Resources
Strategic Options for Allocating Company
Financial Resources
Financial Options for Allocating Company
Financial Resources
Invest in ways to strengthen or grow existing businesses
Pay o� existing long-term or short-term debt
Fund long-range R&D ventures aimed at opening market opportunities
in new or existing businesses
Increase dividend payments to shareholders
Build cash reserves; invest in short-term securities
Make acquisitions to establish positions in new industries or to complement existing businesses
Repurchase shares of the company’s common stock
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Sticking Closely with the Present Business Lineup The option of sticking with the current business lineup makes sense when the company’s exist- ing businesses offer attractive growth opportunities and can be counted on to create economic value for shareholders. As long as the company’s set of existing businesses have good prospects and are in alignment with the company’s diversification strategy, then major changes in the company’s business mix are unnecessary. Corporate execu- tives can concentrate their attention on getting the best performance from each of the businesses, steering corporate resources into the areas of greatest potential and profit- ability. The specifics of “what to do” to wring better performance from the present business lineup have to be dictated by each business’s circumstances and the preceding analysis of the corporate parent’s diversification strategy.
Broadening a Diversified Company’s Business Base Diversified companies sometimes find it desirable to build positions in new industries, whether related or unrelated. Several motivating factors are in play. One is sluggish growth
FIGURE 8.6 A Company’s Four Main Strategic Alternatives after It Diversifies
Restructure the Company’s Business Lineup through a Mix of Divestitures and New Acquisitions Sell o� competitively weak businesses in unattractive industries, businesses with little strategic or resource fit, and noncore businesses. Use cash from divestitures plus unused debt capacity to make acquisitions in other, more promising industries.
Strategy Options for a Company
That Is Already Diversified
Stick Closely with the Existing Business Lineup Makes sense when the current business lineup o�ers attractive growth opportunities and can generate added economic value for shareholders.
Broaden the Diversification Base Acquire more businesses and build positions in new related or unrelated industries. Add businesses that will complement and strengthen the market position and competitive capabilities of business in industries where the company already has a stake.
Divest Some Businesses and Retrench to a Narrower Diversification Base Get out of businesses that are competitively weak, that are in unattractive industries, or that lack adequate strategic and resource fit. Focus corporate resources on businesses in a few, carefully selected industry arenas.
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that makes the potential revenue and profit boost of a newly acquired business look attractive. A second is the potential for transferring resources and capabilities to other related or complementary businesses. A third is rapidly changing conditions in one or more of a company’s core businesses, brought on by technological, legislative, or demographic changes. For instance, the passage of legislation in the United States allowing banks, insurance companies, and stock brokerages to enter each other’s busi- nesses spurred a raft of acquisitions and mergers to create full-service financial enter- prises capable of meeting the multiple financial needs of customers. A fourth, and very important, motivating factor for adding new businesses is to complement and strengthen the market position and competitive capabilities of one or more of the com- pany’s present businesses. Procter & Gamble’s acquisition of Gillette strengthened and extended P&G’s reach into personal care and household products—Gillette’s busi- nesses included Oral-B toothbrushes, Gillette razors and razor blades, Duracell batter- ies, Braun shavers, small appliances (coffeemakers, mixers, hair dryers, and electric toothbrushes), and toiletries.
Another important avenue for expanding the scope of a diversified company is to grow by extending the operations of existing businesses into additional country markets, as discussed in Chapter 7. Expanding a company’s geographic scope may offer an exceptional competitive advantage potential by facilitating the full capture of economies of scale and learning- and experience-curve effects. In some businesses, the volume of sales needed to realize full economies of scale and/or benefit fully from experience-curve effects exceeds the volume that can be achieved by operating within the boundaries of just one or several country markets, especially small ones.
Retrenching to a Narrower Diversification Base A number of diversified firms have had difficulty managing a diverse group of businesses and have elected to exit some of them. Selling a business outright to another company is far and away the most frequently used option for divesting a business. In 2012, Sara Lee Corporation sold its International Coffee and Tea business to J.M. Smucker, while Nike sold its Umbro and Cole Haan brands to focus on brands like Jordan and Converse that are more complementary to the Nike brand. But sometimes a business selected for divestiture has ample resources and capabilities to compete successfully on its own. In such cases, a corporate parent may elect to spin the unwanted business off as a financially and managerially independent company, either by selling shares to the public via an initial public offering or by distributing shares in the new company to shareholders of the corporate parent. In 2015, health care company Baxter Interna- tional spun off its biotech arm into a new company, Baxalta, leaving its parent com- pany to focus on medical products and equipment. eBay spun off PayPal in 2015 at a valuation of $45 billion—a value 30 times more than what eBay paid for the company in a 2002 acquisition.
Retrenching to a narrower diversification base is usually undertaken when top management concludes that its diversification has ranged too far afield and that the company can improve long-term performance by concentrating on a smaller number of businesses. But there are other important reasons for divesting one or more of a company’s present businesses. Sometimes divesting a business has to be considered because market conditions in a once-attractive industry have badly deteriorated. A business can become a prime candidate for divestiture because it lacks adequate strategic or resource fit, because it is a cash hog with question- able long-term potential, or because remedying its competitive weaknesses is too expensive relative to the likely gains in profitability. Sometimes a company
A spin-off is an independent company created when a corporate parent divests a business either by selling shares to the public via an initial public offering or by distributing shares in the new company to shareholders of the corporate parent.
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acquires businesses that, down the road, just do not work out as expected even though management has tried its best. Subpar performance by some business units is bound to occur, thereby raising questions of whether to divest them or keep them and attempt a turnaround. Other business units, despite adequate financial performance, may not mesh as well with the rest of the firm as was originally thought. For instance, PepsiCo divested its group of fast-food restaurant businesses to focus on its core soft-drink and snack-food businesses, where their specialized resources and capabilities could add more value.
On occasion, a diversification move that seems sensible from a strategic-fit stand- point turns out to be a poor cultural fit.18 When several pharmaceutical companies diversified into cosmetics and perfume, they discovered their personnel had little respect for the “frivolous” nature of such products compared to the far nobler task of developing miracle drugs to cure the ill. The absence of shared values and cultural compatibility between the medical research and chemical-compounding expertise of
the pharmaceutical companies and the fashion and marketing orientation of the cosmetics business was the undoing of what otherwise was diversification into businesses with technology-sharing potential, product development fit, and some overlap in distribution channels.
A useful guide to determine whether or when to divest a business subsidiary is to ask, “If we were not in this business today, would we want to get into it now?” When the answer is no or probably not, divestiture should be considered. Another signal that a business should be divested occurs when it is worth more to another company than to the present parent; in such cases, shareholders would be well served if the company sells the business and collects a premium price from the buyer for whom the business is a valuable fit.
Restructuring a Diversified Company’s Business Lineup Restructuring a diversified company on a companywide basis (corporate restruc- turing) involves divesting some businesses and/or acquiring others, so as to put a whole new face on the company’s business lineup.19 Performing radical surgery on a company’s business lineup is appealing when its financial performance is being squeezed or eroded by:
CORE CONCEPT
Companywide restructuring (corporate restructuring) involves making major changes in a diversified company by divesting some businesses and/or acquiring others, so as to put a whole new face on the company’s business lineup.
Diversified companies need to divest low-performing businesses or businesses that don’t fit in order to concentrate on expanding existing businesses and entering new ones where opportunities are more promising.
∙ A serious mismatch between the company’s resources and capabilities and the type of diversification that it has pursued.
∙ Too many businesses in slow-growth, declining, low-margin, or otherwise unat- tractive industries.
∙ Too many competitively weak businesses. ∙ The emergence of new technologies that threaten the survival of one or more
important businesses. ∙ Ongoing declines in the market shares of one or more major business units that
are falling prey to more market-savvy competitors. ∙ An excessive debt burden with interest costs that eat deeply into profitability. ∙ Ill-chosen acquisitions that haven’t lived up to expectations.
On occasion, corporate restructuring can be prompted by special circumstances— such as when a firm has a unique opportunity to make an acquisition so big and important that it has to sell several existing business units to finance the new
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acquisition or when a company needs to sell off some businesses in order to raise the cash for entering a potentially big industry with wave-of-the-future technologies or products. As businesses are divested, corporate restructuring generally involves align- ing the remaining business units into groups with the best strategic fit and then rede- ploying the cash flows from the divested businesses to either pay down debt or make new acquisitions to strengthen the parent company’s business position in the industries it has chosen to emphasize.
Over the past decade, corporate restructuring has become a popular strategy at many diversified companies, especially those that had diversified broadly into many different industries and lines of business. VF Corporation, maker of North Face and other popular “lifestyle” apparel brands, has used a restructuring strategy to provide its shareholders with returns that are more than five times greater than shareholder returns for competing apparel makers. Since its acquisition and turnaround of North Face in 2000, VF has spent nearly $5 billion to acquire 19 additional businesses, including about $2 billion in 2011 for Timberland. New apparel brands acquired by VF Corporation include 7 For All Mankind sportswear, Vans skateboard shoes, Nau- tica, John Varvatos, Reef surf wear, and Lucy athletic wear. By 2015, VF Corporation had become a $12 billion powerhouse—one of the largest and most profitable apparel and footwear companies in the world. It was listed as number 248 on Fortune’s 2015 list of the 500 largest U.S. companies.
Illustration Capsule 8.2 discusses how Hewlett-Packard (HP) has been restructur- ing its operations to address internal problems and improve its profitability.
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ILLUSTRATION CAPSULE 8.2
Since its misguided acquisition of PC maker Compaq (under former CEO Carly Fiorina), Hewlett-Packard has been struggling. In the past few years, it has faced declining demand, rapid technological change, and fierce new competitors, such as Google and Apple, in its core markets. To address these problems, CEO Meg Whitman announced a restructuring of the company that was approved by the company’s board of directors in October 2015. In addition to trimming operations, the plan was to split the company into two independent entities: HP Inc. and HP Enterprise. The former would primarily house the company’s legacy PC and printer businesses, while the latter would retain the company’s
technology infrastructure, services, and cloud comput- ing businesses.
A variety of benefits were anticipated as a result of this fundamental reshaping of the company. First, the split would enable the faster-growing enterprise busi- ness to pursue opportunities that are less relevant to the concerns of its more staid sister business. As several have observed, “it is hard to be good at both consumer and enterprise computing,” which suggests an absence of strategic fit along the value chains of the two newly separated businesses. Second, in creating smaller, more nimble entities, the new companies would be better posi- tioned to respond to competitive moves and anticipate the evolving needs of customers. This is primarily because management teams would be responsible for a smaller, more focused set of products, which would leave them better equipped to innovate in the fast-moving world of technology. Third, the more streamlined organizations would better align incentives for managers, since they would be more likely to see their individual efforts hit the bottom line under a more focused operation.
By cutting back operations to match areas of declin- ing demand and moving some operations overseas, the company anticipates a reduction in costs of more than $2 billion. And while this will be offset by the costs of restructuring (including the need for duplicate adminis- trative functions), the hope is that, overall, these moves will soon return the company to profitability.
Restructuring for Better Performance at Hewlett- Packard (HP)
© Angel Navarrete/Bloomberg via Getty Images
Note: Developed with Ken Martin, CFA.
Sources: CNBC Online, “Former HP Chair: Spinoff Not a Defensive Play,” October 6, 2015, w w w.cnbc.com/2014/10/06/hairman-spin- off-not-a- defensive- play.html; S. Mukherjee and E. Chan, Reuters Online, “Hewlett-Packard to Split into Two Public Companies, Lay Off 5,000,” October 6, 2015, w w w.reuters .com/article/us-hp -restructuring-idUSKCN0HV0U720141006; J. Vanian, Fortune Online, “How Hewlett-Packard Plans to Split in Two,” July 1, 2015, fortune.com/2015/07/01/hewlett-packard-filing-split/; company website (accessed March 3, 2016).
KEY POINTS
1. A “good” diversification strategy must produce increases in long-term share- holder value—increases that shareholders cannot otherwise obtain on their own. For a move to diversify into a new business to have a reasonable prospect of add- ing shareholder value, it must be capable of passing the industry attractiveness test, the cost-of-entry test, and the better-off test.
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2. Entry into new businesses can take any of three forms: acquisition, internal startup, or joint venture. The choice of which is best depends on the firm’s resources and capabilities, the industry’s entry barriers, the importance of speed, and relative costs.
3. There are two fundamental approaches to diversification—into related businesses and into unrelated businesses. The rationale for related diversification is to ben- efit from strategic fit: Diversify into businesses with commonalities across their respective value chains, and then capitalize on the strategic fit by sharing or trans- ferring the resources and capabilities across matching value chain activities to gain competitive advantages.
4. Unrelated diversification strategies surrender the competitive advantage poten- tial of strategic fit at the value chain level in return for the potential that can be realized from superior corporate parenting or the sharing and transfer of general resources and capabilities. An outstanding corporate parent can benefit its busi- nesses through (1) providing high-level oversight and making available other cor- porate resources, (2) allocating financial resources across the business portfolio, and (3) restructuring underperforming acquisitions.
5. Related diversification provides a stronger foundation for creating shareholder value than does unrelated diversification, since the specialized resources and capabilities that are leveraged in related diversification tend to be more valu- able competitive assets than the general resources and capabilities underlying unrelated diversification, which in most cases are relatively common and easier to imitate.
6. Analyzing how good a company’s diversification strategy is consists of a six-step process:
Step 1: Evaluate the long-term attractiveness of the industries into which the firm has diversified. Determining industry attractiveness involves developing a list of industry-attractiveness measures, each of which might have a different importance weight. Step 2: Evaluate the relative competitive strength of each of the company’s busi- ness units. The purpose of rating the competitive strength of each business is to gain a clear understanding of which businesses are strong contenders in their industries, which are weak contenders, and what the underlying reasons are for their strength or weakness. The conclusions about industry attractiveness can be joined with the conclusions about competitive strength by drawing a nine-cell industry-attractiveness–competitive-strength matrix that helps identify the pros- pects of each business and the level of priority each business should be given in allocating corporate resources and investment capital. Step 3: Check for the competitive value of cross-business strategic fit. A business is more attractive strategically when it has value chain relationships with the other business units that offer the potential to (1) combine operations to realize econo- mies of scope, (2) transfer technology, skills, know-how, or other resource capa- bilities from one business to another, (3) leverage the use of a trusted brand name or other resources that enhance differentiation, (4) share other competitively valu- able resources among the company’s businesses, and (5) build new resources and competitive capabilities via cross-business collaboration. Cross-business strategic fit represents a significant avenue for producing competitive advantage beyond what any one business can achieve on its own.
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