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Making Diversification Work (1 of 2)
Diversification initiatives must create value for shareholders through
Mergers and acquisitions
Strategic alliances
Joint ventures
Internal development
Diversification should create synergy.
Business 1 plus Business 2 equals More than two.
©McGraw-Hill Education.
Diversification = the process of firms expanding their operations by entering new businesses. Diversification initiatives – whether through mergers and acquisitions, strategic alliances and joint ventures, or internal development – must be justified by the creation of value for shareholders. But this is not always the case. Firms typically pay high premiums when they acquire a target firm. So why should companies even bother with diversification initiatives? The answer is synergy, which means “working together,” and synergistic effects should be multiplicative – one plus one should equal more than two.
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Making Diversification Work (2 of 2)
A firm may diversify into related businesses.
Benefits derive from horizontal relationships.
Sharing intangible resources such as core competencies in marketing
Sharing tangible resources such as production facilities, distribution channels via vertical integration
A firm may diversify into unrelated businesses.
Benefits derive from hierarchical relationships.
Value creation derived from the corporate office
Leveraging support activities in the value chain
©McGraw-Hill Education.
Related businesses are those that share resources. Unrelated businesses have few similarities in products or industries, however the corporate office can add value through such activities as robust information systems or superb human resource practices. Benefits derived from horizontal (related diversification) and hierarchical (unrelated diversification) relationships are not mutually exclusive. Many firms that diversify into related areas benefit from information technology expertise in the corporate office. Similarly, unrelated diversifiers often benefit from the “best practices” of sister businesses even though their products, markets, and technologies may differ dramatically. An example would be a corporate parent with strong support activities in the value chain such as information systems or human resource practices.
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Related Diversification
Related diversification enables a firm to benefit from horizontal relationships across different businesses.
Economies of scope allow businesses to:
Leverage core competencies
Share related activities
Enjoy greater revenues, enhance differentiation
Related businesses gain market power by:
Pooled negotiating power
Vertical integration
©McGraw-Hill Education.
Related diversification = a firm entering a different business in which it can benefit from leveraging core competencies, sharing activities, or building market power. Economies of scope = cost savings from leveraging core competencies or sharing related activities among businesses in a corporation. Core competencies = a firm’s strategic resources that reflect the collective learning in the organization. Sharing activities = having activities of two or more businesses’ value chains done by one of the businesses. A firm can also enjoy greater revenues if two businesses attain higher levels of sales growth combined than either company could attain independently (this is the synergistic effect). Firms also can enhance the effectiveness of their differentiation strategies by means of sharing activities among business units. A shared order-processing system, for example, may permit new features and services that a buyer will value. Market power = firms’ abilities to profit through restricting or controlling supply to a market or coordinating with other firms to reduce investment. Pooled negotiation power = the improvement in bargaining position relative to suppliers and customers. Be careful, though: acquiring related businesses can enhance a corporation’s bargaining power, but it must be aware of the potential for retaliation. Vertical integration = an expansion or extension of the firm by integrating preceding or successive production processes. Vertical integration occurs when a firm becomes its own supplier or distributor.
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Related Diversification: Market Power
Market power can lead to the creation of value and synergy through…
Pooled negotiating power
Gaining greater bargaining power with suppliers & customers
Vertical integration - becoming its own supplier or distributor through
Backward integration
Forward integration
©McGraw-Hill Education.
Market power = firms’ abilities to profit through restricting or controlling supply to a market or coordinating with other firms to reduce investment. Pooled negotiating power = the improvement in bargaining position relative to suppliers and customers. Similar businesses working together or the affiliation of the business with a strong parent can strengthen an organization’s purchasing clout. However, managers must carefully evaluate how the combined businesses may affect relationships with actual and potential customers, suppliers, and competitors – they may retaliate! Vertical integration = an expansion or extension of the firm by integrating preceding or successive production processes. Vertical integration occurs when a firm becomes its own supplier or distributor. The firm can incorporate more processes toward the original source of raw materials (backward integration) or toward the ultimate consumer (forward integration).
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Example: Related Diversification: Vertical Integration
Example: Simplified Stages of Vertical Integration: Shaw Industries
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Vertical integration can be a viable strategy for many firms. Shaw Industries is a carpet maker that has attained a dominant position in the industry via a strategy of vertical integration. Shaw has successfully implemented strategies of both forward AND backward integration.
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Related Diversification: Vertical Integration, Issues
Is the company satisfied with the quality of the value that its present suppliers & distributors are providing?
Are there activities in the industry value chain presently being outsourced or performed independently by others that are a viable source of future profits?
Is there a high level of stability in the demand for the organization’s products?
Does the company have the necessary competencies to execute the vertical integration strategies?
Will the vertical integration initiatives have potential negative impacts on the firm’s stakeholders?
©McGraw-Hill Education.
In making vertical integration decisions, five issues should be considered. If the performance of organizations in the vertical chain is satisfactory, it may not, in general, be appropriate for a company to perform these activities itself. However, even if a firm IS outsourcing value-chain activities to companies that are doing a credible job, it may be missing out on substantial profit opportunities. Note: high demand or sales volatility are not that conducive to vertical integration. With a high level of fixed costs in plant and equipment as well as operating costs that accompany endeavors toward vertical integration, widely fluctuating sales demand can either strain resources (in times of high demand) or result in unused capacity (in times of low demand). Finally, successfully executing strategies of vertical integration can be very difficult and can require significant competencies. In addition, managers must carefully consider the impact that vertical integration may have on existing and future customers, suppliers, and competitors.
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Related Diversification: Vertical Integration, Transaction Costs
Transaction cost perspective
Every market transaction involves some transaction costs.
Search costs
Negotiating costs
Contract costs
Monitoring costs
Enforcement costs
Need for transaction specific investments
Administrative costs
©McGraw-Hill Education.
Transaction cost perspective = a perspective that the choice of a transaction’s governance structure, such as vertical integration or market transaction, is influenced by transaction costs, including search, negotiating, contracting, monitoring, and enforcement costs, associated with each choice. Transaction costs are the sum of the above costs. These transaction costs can be avoided by internalizing the activity, in other words, by producing the input in-house. However, vertical integration gives rise to administrative costs as well. Coordinating different stages of the value chain now internalized within the firm causes administrative costs to go up. Decisions about vertical integration are, therefore, based on a comparison of transaction costs and administrative costs. If transaction costs are lower than administrative costs, it is best to resort to market transactions and avoid vertical integration. On the other hand, if transaction costs are higher than administrative costs, vertical integration becomes an attractive strategy.
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Means of Diversification
Diversification can be accomplished via
Mergers & acquisitions
And divestment
Pooling resources of other companies with a firm’s own resource base through
Strategic alliances & joint ventures
Internal Development through
Corporate entrepreneurship
New venture development
©McGraw-Hill Education.
Diversification, either related or unrelated, allows a firm to achieve synergies and create value for its shareholders. There are three basic means by which a firm can diversify. Mergers = the combining of two or more firms into one new legal entity. Acquisitions = the incorporation of one firm into another through purchase. Through mergers and acquisitions, corporations can directly acquire another firm’s assets and competencies. A firm can also divest previous acquisitions. Divestment = the exit of a business from the firm’s portfolio. By using a joint venture or strategic alliance, corporations can pool the resources of other companies with their own resource base. Strategic alliance = a cooperative relationship between two or more firms. Joint ventures = new entities formed within a strategic alliance in which two or more firms, the parents, contribute equity to form the new legal entity. Finally, corporations may diversify into new products, markets, and technologies through internal development. Internal development = entering a new business through investment in new facilities, often called corporate entrepreneurship and new venture development. Corporate entrepreneurship involves the leveraging and combining of the firm’s own resources and competencies to create synergies and enhance shareholder value.
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Mergers and Acquisitions
Mergers involve a combination or consolidation of two firms to form a new legal entity.
Relatively rare
On a relatively equal basis
Acquisitions involve one firm buying another either through stock purchase, cash, or the issuance of debt.
©McGraw-Hill Education.
The most visible and often costly means to diversify is through acquisitions. Exhibit 6.5 illustrates the dramatic volatility in worldwide M&A activity over the last several years. Increase in merger and acquisition activity can indicate market optimism. It’s an indication that markets are willing to finance these transactions. Government policies such as regulatory actions and tax policies can also make the M&A environment more or less favorable. Finally, currency fluctuations can influence the rate of cross-border acquisitions with firms in countries with stronger currencies being in a stronger position to acquire.
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Mergers and Acquisitions: Motives
In high-technology & knowledge-intensive industries, speed is critical: acquiring is faster than building.
M&A allows a firm to obtain valuable resources that help it expand its product offerings & services.
M&A helps a firm develop synergy.
Leveraging core competencies
Sharing activities
Building market power
M&A can lead to consolidation within an industry, forcing other players to merge.
Corporations can also enter new market segments by way of acquisitions.
©McGraw-Hill Education.
In certain industries speed is critical, so acquiring is faster than building. Example = Apple acquiring Siri Inc. Acquisitions can quickly add new technology to product offerings and meet changing customer needs. Example = Cisco Systems. Acquisitions can help a firm leverage core competencies, share activities, and build market power. Example = eBay’s acquisition of GSI Commerce, StubHub and Gmarket allows it to become a full-service provider of online retailing systems. M&A can lead to consolidation within an industry, forcing other players to merge. Example = consolidation in the airline industry: Delta – Northwest, United – Continental. Corporations can also enter a new market segments by way of acquisitions. Example = Fiat acquired Chrysler to gain access to the U.S. auto market. See Exhibit 6.6.
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Mergers and Acquisitions: Limitations
Takeover premiums for acquisitions are typically very high.
Competing firms can imitate advantages.
Competing firms can copy synergies.
Managers’ egos get in the way of sound business decisions
Cultural issues may doom the intended benefits.
©McGraw-Hill Education.
By estimates, 70 to 90% of acquisitions destroy shareholder value. See Strategy Spotlight 6.4. Two times out of three, the stock price of the acquiring company falls once the deal is made public. Since the acquiring firm often pays a 30% or higher premium for the target company, the acquirer must create synergies and scale economies that result in sales and market gains exceeding the premium price. This is sometimes hard to do. Because competing firms can often imitate advantages or copy synergies, investors may not be willing to pay a high premium for the stock. M&A costs are paid for upfront. Conversely, firms pay for R&D, ongoing marketing, and capacity expansion over time. This stretches out the payments needed to gain new competencies, but investors want to see immediate results. If the M&A does not perform as planned, managers who pushed for the deal may find their reputation tarnished. Finally, creating a singular organizational culture from multiple national or business cultures can be very difficult. Example = SmithKline and the Beecham Group.
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Question (2 of 2)
Divestment can be the common result of an acquisition. Divesting businesses can accomplish many different objectives. These include
enabling managers to focus their efforts more directly on the firm’s core businesses.
providing the firm with more resources to spend on more attractive alternatives.
raising cash to help fund existing businesses.
all of the above.
©McGraw-Hill Education.
Answer: D. Divestment = the exit of a business from the firm’s portfolio. See limitations of mergers and acquisitions, and how divesting a business can accomplish many different objectives, as on the next slide.
.
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Mergers and Acquisitions: Divestment Objectives
Divestment objectives include:
Cutting the financial losses of a failed acquisition
Redirecting focus on the firm’s core businesses
Freeing up resources to spend on more attractive alternatives
Raising cash to help fund existing businesses
©McGraw-Hill Education.
Divestments, the exit of the business from the firm’s portfolio, are quite common. Large, prestigious U.S. companies may have divested more acquisitions than they have kept. Investing can enhance a firm’s competitive position only to the extent that it reduces its tangible (e.g., maintenance, investments, etc.) or intangible (e.g., opportunity costs, managerial attention) costs without sacrificing a current competitive advantage or the seeds of future advantages. To be effective, divesting requires a thorough understanding of the business unit’s current ability and future potential to contribute to a firm’s value creation. Modes of divestment include sell-offs, spin-offs, equity carve-outs, asset sales/dissolution, and split-ups.
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Mergers and Acquisitions: Divestment Success
Successful divestiture involves:
Removing emotion from the decision
Knowing the value of the business you’re selling
Timing the deal right
Maintaining a sizable pool of potential buyers
Telling a story about the deal
Running divestitures systematically through a project office
Communicating clearly and frequently
©McGraw-Hill Education.
Successful divestment requires a thorough understanding of a business unit’s current ability and future potential to contribute to a firm’s value creation. Since the decision to divest involves a great deal of uncertainty, it’s very difficult to make such evaluations. In addition, because of managerial self interests and organizational inertia, firms often delay investments of underperforming businesses. The Boston Consulting Group has identified the above seven principles for successful divestiture.
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Strategic Alliances & Joint Ventures: Motives
Strategic alliances & joint ventures are cooperative relationships between two (or more) firms with potential advantages.
Ability to enter new markets through
Greater financial resources
Greater marketing expertise
Ability to reduce manufacturing or other costs in the value chain
Ability to develop & diffuse new technologies
©McGraw-Hill Education.
Strategic alliances and joint ventures are assuming an increasingly prominent role in the strategy of leading firms, both large and small. A strategic alliance can help firms better understand customer needs, acquire know-how for promoting the product, acquire access to the proper distribution channels. Example = Zara cooperating with Tata in India. Strategic alliances enable firms to pool capital, value-creating activities, or facilities in order to reduce costs. Example = PGA and LPGA tours joined together to save costs in marketing and joint utilization of media platforms. Strategic alliances may also be used to build jointly on the technological expertise of two or more companies, enabling them to develop products beyond the capability of other companies acting independently. Example = alliance between Ericsson and Cisco in Strategy Spotlight 6.5 allowed for development of new telecommunication equipment.
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Strategic Alliances & Joint Ventures: Limitations
Need for the proper partner:
Partners should have complementary strengths.
Partner’s strengths should be unique.
Uniqueness should create synergies.
Synergies should be easily sustained & defended.
Partners must be compatible & willing to trust each other.
©McGraw-Hill Education.
Despite their promise, many alliances and joint ventures fail to meet expectations for a variety of reasons. The proper partner is essential. However, unfortunately, often little attention is given to nurturing the close working relationship and interpersonal connections that bring together the partnering organizations.
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Internal Development
Corporate entrepreneurship & new venture internal development motives:
No need to share the wealth with alliance partners.
No need to face difficulties associated with combining activities across the value chains.
No need to merge diverse corporate cultures.
No need for external funding for new development.
Limitations:
Time-consuming
Need to continually develop new capabilities
©McGraw-Hill Education.
Internal development = entering a new business through investment in new facilities, often called corporate entrepreneurship and new venture development. Internal development is such an important means by which companies expand their businesses that there’s a whole chapter devoted to it – see Chapter 12. Compared to mergers and acquisitions, firms that engage in internal development capture the value created by their own innovative activities without having to share the wealth with alliance partners or face the difficulties associated with combining activities across the value chains of several firms or merging corporate cultures. On their own, firms can often develop new products or services that are relatively lower cost, and thus rely on their own resources rather than turning to external funding. However this may be time-consuming, so firms may forfeit the benefits of speed that growth through mergers or acquisitions can provide. In addition, firms that choose to diversify through internal development must develop capabilities that allow them to move quickly from initial opportunity recognition to market introduction.
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