CHAPTER 6 CORPORATE-LEVEL STRATEGY’S VALUE

CORPORATE-LEVEL STRATEGY
■ Corporate-level strategy’s value is ultimately
determined by the degree to which “the businesses
in the portfolio are worth more under the
management of the company than they would be
under any other ownership”

■ A corporate-level strategy is expected to help the

firm earn above-average returns by creating value

CORPORATE–LEVEL STRATEGY: DIVERSIFICATION

DIVERSIFICATION - growing into new business areas

either related (similar to existing business) or
unrelated (different from existing business); allows a
firm to create value by productively using excess
resources.

■ The diversified firm operates in several

different and unique product markets and
likely in several businesses; it forms two types
CORPORATE–LEVEL STRATEGY: WHAT
of strategies: corporate-level (or company-
BUSINESSES SHOULD A FIRM COMPETE IN?
wide) and business-level (or competitive)
TWO KEY ISSUES
■ For the diversified corporation, a business-
1. In what product markets and businesses level strategy must be selected for each one
should the firm compete? of its businesses
2. How should corporate headquarters
ONE BUSINESS-LEVEL STRATEGY
manage those businesses?
• A single-product market/single geographic
■ Specifies actions a firm takes to gain a competitive location firm employs one business-level
advantage by selecting and managing a group of strategy and one corporate-level strategy
different businesses competing in different product identifying what or which industry the firm will
markets. compete in
■ Corporate-level strategies help companies select SEVERAL BUSINESS-LEVEL STRATEGIES
new strategic positions that are expected to
increase the firm’s value. • A diversified firm employs a separate
business-level strategy for each product
■ Firms can pursue defensive or offensive strategies market area in which it competes and one or
that realize growth, and may have different strategic more corporate-level strategies dealing with
intents. product and/or geographic diversity
CORPORATE–LEVEL STRATEGIES PRODUCT DIVERSIFICATION - a primary form of
corporate-level strategies; concerns the scope of
 MARKET DEVELOPMENT - moving into
the markets and industries in which the firm
different geographic markets
competes
 PRODUCT DEVELOPMENT - developing new
products and/or significantly improving on ■The ideal portfolio of businesses balances
existing products diversification’s costs and benefits:
 HORIZONTAL INTEGRATION - acquisition of
competitors; horizontal movement at the ■ Reduction in profitability variability as earnings
same point in the value chain are generated from different businesses
 VERTICAL INTEGRATION - becoming your own ■Independence/flexibility to shift investments
supplier or distributor through acquisition; to those markets with the greatest returns
vertical movement up or down the value
chain This chapter focuses on DIVERSIFICATION.
■ VALUE CREATION: low – high levels of diversification - Mixed: Linked firms sharing fewer resources
and assets among their businesses
● The sharing of resources (the related
(compared with related constrained),
constrained strategy)
concentrating on the transfer of knowledge
● The transferring of core competencies and competencies among the businesses
across the firm’s different businesses (the
3. Very High Levels: Unrelated
related linked strategy)
- Less than 70% of revenue comes from
● Managerial motives to diversify can
dominant business
actually destroy some of the firm’s value
- No relationships between businesses
LEVELS OF DIVERSIFICATION
REASONS FOR DIVERSIFICATION

1. Low Levels

 Single Business Strategy

- Corporate-level strategy in which the firm
generates 95% or more of its sales
revenue from its core business area
 Dominant Business Diversification Strategy
- Corporate-level strategy whereby firm
generates 70-95% of total sales revenue
within a single business area

2. Moderate to High Levels

 Related Constrained Diversification Strategy

- Less than 70% of revenue comes from the
dominant business
- Direct links (i.e., share products,
technology, and distribution linkages)
between the firm's businesses

 Related Linked Diversification Strategy

(mixed related and unrelated)

- Less than 70% of revenue comes from the

dominant business
  One way managers facilitate the transfer of
corporate-level core competencies is by
VALUE-CREATING DIVERSIFICATION: RELATED
moving key people into new management
CONSTRAINED AND RELATED LINKED
positions.
DIVERSIFICATION
 However, the manager of an older business
FIRM CREATES VALUE BY BUILDING UPON OR may be reluctant to transfer key people who
EXTENDING: have accumulated knowledge and
experience critical to the business’s success.
• Resources  Too much dependence on outsourcing can
• Capabilities lower the usefulness of core competencies
• Core competencies and thereby reduce their useful transferability
PURPOSE: gain market power relative to competitors to other business units in the diversified firm.
ADVANTAGE: ECONOMIES OF SCOPE MARKET POWER
 Cost savings that occur when a firm transfers Relevant for:
capabilities and competencies developed
in one of its businesses to another of its  RELATED CONSTRAINED
businesses  RELATED LINKED
 Operational relatedness in sharing activities
■ Exists when a firm is able to sell its products above
 Corporate relatedness in transferring skills or
the existing competitive level, to reduce costs of
corporate core competencies among units
primary and support activities below the competitive
 The difference between sharing activities
level, or both
and transferring competencies is based on
how the resources are jointly used to create ■ Related diversification strategy may include:
economies of scope
 Vertical integration
OPERATIONAL RELATEDNESS: SHARING ACTIVITIES
• Backward integration: a firm
 Can gain economies of scope produces its own inputs
 Share primary or support activities (in value
• Forward integration: a firm operates
chain), e.g., a primary activity such as
its own distribution system for
inventory delivery systems, or a support
delivering its outputs
activity such as purchasing
 Risky as ties create links between outcomes  Virtual integration
 Related constrained share activities in order
to create value ■ Multimarket (or Multipoint) Competition
 Not easy, often synergies not realized as
● Exists when two or more diversified firms
planned
simultaneously compete in the same product
CORPORATE RELATEDNESS: TRANSFERRING OF CORE or geographic markets
COMPETENCIES
EXAMPLE: GOOGLE (Strategic Focus)
 Complex sets of resources and capabilities
■ Google is diversifying into new
linking different businesses through
markets that allow it to engage in
managerial and technological knowledge,
multipoint competition, e.g.,
experience, and expertise
competing with Microsoft and Apple
TWO SOURCES OF VALUE CREATION in several markets

1. Expense incurred in first business and ■ MARKET POWER: while Google appears to be
knowledge transfer reduces resource increasing its vertical integration, many
allocation for second business manufacturing firms have been reducing vertical
2. Intangible resources difficult for integration to gain market power
competitors to understand and imitate,
■ DEINTEGRATION: developing independent supplier
so immediate competitive advantage
networks - the focus of many manufacturing firms,
over competition
such as Intel and Dell, and Ford and General Motors
SIMULTANEOUS OPERATIONAL RELATEDNESS AND ● EQUITY - investors take equity positions
CORPORATE RELATEDNESS (ownership) with high expected future cash-flow
values.
■ The ability to simultaneously create economies of
scope by sharing activities (operational relatedness) ● DEBT - debt holders try to improve the value of
and transferring core competencies (corporate their investments by taking \ stakes in businesses
relatedness) is difficult for competitors to understand with high growth and profitability prospects
and learn how to imitate
INTERNAL CAPITAL MARKET - In large diversified firms,
■ Involves managing two sources of knowledge capital distributions may generate gains from
simultaneously: internal capital market allocations that

1. Operational forms of economies of scope EXCEED

2. Corporate forms of economies of scope
EXTERNAL CAPITAL MARKET - the gains that would
accrue to shareholders from capital being allocated
■ Many such efforts often fail because of
by the external capital market
implementation difficulties
CONGLOMERATE DISCOUNT
■ If the cost of realizing both types of relatedness is
not offset by the benefits created, the result is ■ This discount results from analysts not
DISECONOMIES because the cost of organization knowing how to value a vast array of large
and incentive structure is very expensive businesses with complex financial reports.
EXAMPLE: Walt Disney Co. ■ Stock markets apply a “Conglomerate
Discount” of 20% on unrelated diversified
■ Walt Disney Co. has been able to
firms, which means that investors believe that
successfully use related diversification as a
the value of conglomerates is 20% less than
corporate-level strategy through which it
the value of the sum of their parts.
creates economies of scope by sharing some
activities and by transferring core ■ To overcome this discount, many unrelated
competencies diversifiers or conglomerates have sought to
establish a brand for the parent company .
■ Because this value creation can be difficult
for investors to see, the value of the assets of ACHILLES’ HEEL - Financial economies are more
a firm using a diversification strategy to easily duplicated by competitors than are gains from
create economies of scope often is operational and corporate relatedness.
discounted by investors
• This issue is less of a problem in emerging
UNRELATED DIVERSIFICATION economies, where the absence of a “soft
infrastructure” (including effective financial
Creates value through two types of FINANCIAL
intermediaries, sound regulations, and
ECONOMIES.
contract laws) supports and encourages use
1. Cost savings realized through improved of the unrelated diversification strategy
allocations of financial resources based on
• In emerging economies such as those in
investments inside or outside firm
Korea, India, and Chile, research has shown
 Efficient internal capital market
that diversification increases the
allocation
performance of firms affiliated with large
2. Restructuring of acquired assets
diversified business groups
 Firm A buys firm B and restructures assets
so it can operate more profitably, then A RESTRUCTURING OF ASSETS
sells B for a profit in the external market
Restructuring creates financial economies.
EFFICIENT INTERNAL CAPITAL MARKET ALLOCATION
• A firm creates value by buying, restructuring,
● In a market economy, capital markets then selling the restructured firms’ assets in
allocate capital efficiently the external market.
 • An economic downturn can present  Treated capital gains as ordinary
opportunities but also some risks. income

Resource allocation decisions may become  Thus created incentive for

complex, so success often requires: shareholders to prefer dividends to
acquisition investments, as the 1986
• Focus on mature, low-technology businesses
Tax Reform Act diminished some of
• Focus on businesses not reliant on a client the corporate tax advantages of
orientation diversification

DIVERSIFICATION ADVANTAGES Internal incentives

• RELATED DIVERSIFICATION  ECONOMIES 1. Low Performance

OF SCOPE
• High performance eliminates the need for
• UNRELATED DIVERSIFICATION  FINANCIAL greater diversification
ECONOMIES
• Low performance acts as incentive for
VALUE-NEUTRAL DIVERSIFICATION: INCENTIVES AND diversification
RESOURCES
• Firms plagued by poor performance often
Different incentives to diversify exist, and the quality take higher risks (diversification is risky)
of the firm’s resources may permit only diversification
DIVERSIFICATION AND PERFORMANCE
that is value neutral rather than value creating.

INCENTIVES TO DIVERSIFY

External incentives

1. Antitrust Regulation

• Antitrust laws in 1960s and 1970s discouraged

mergers that created increased market
power (vertical or horizontal integration)

• Mergers in the 1960s and 1970s thus tended

to be unrelated (conglomerate)

• 1980s: Relaxation of antitrust enforcement

results in more and larger horizontal mergers

• Late 1990s: Industry-specific deregulation

spurred increased merger activity in banking, 2. Uncertain Future Cash Flows
telecommunications, oil and gas, and
electric utilities • Diversification may be defensive strategy if
the:
• Early 2000s: Antitrust concerns seem to be
emerging and mergers are more closely  Product line matures
scrutinized
 Product line is threatened
2. Tax Laws
 Firm is small and is in a mature or
• High tax rates on dividends cause a maturing industry
corporate shift from dividends to buying and
3. Synergy and Risk Reduction
building companies in high-performance
industries • Synergy exists when the value created by
businesses working together exceeds the
• 1986 Tax Reform Act
value created by them working
 Reduced individual ordinary income independently.
tax rate from 50 to 28 percent
 • But synergy creates joint interdependence DIVERSIFICATION AND FIRM PERFORMANCE
between business units

• A firm may reduce the level of technological

change by operating in more certain
environments—resulting in more related
types of diversification

• A firm may become risk averse, constrain its

level of activity sharing, and forgo potential
benefits of synergy—resulting in more
unrelated types of diversification

RESOURCES AND DIVERSIFICATION

A FIRM MUST HAVE BOTH:

 Incentives to diversify

 The resources required to create value

through diversification—cash and tangible
resources (e.g., plant and equipment)

Value creation is determined more by appropriate

use of resources than by incentives to diversify.

VALUE-REDUCING DIVERSIFICATION: MANAGERIAL

MOTIVES TO DIVERSIFY

Top-level executives may diversify in order to diversity

their own employment risk, as long as profitability
does not suffer excessively

• Diversification adds benefits to top-level

managers but not shareholders

• This strategy may be held in check by

governance mechanisms or concerns for
one’s reputation

MANAGERIAL MOTIVES TO DIVERSIFY

 Managerial risk reduction

 Desire for increased compensation