Chapter 6

Corporate-Level Strategy
Creating Value Through Diversification

SUMMARY/OBJECTIVES
Whereas business-level strategy (Chapter 5) deals with the question of how to compete in a given
industry, corporate level strategy addresses two related issues. These are: (1) what businesses should we
compete in, and (2) how can these businesses be managed in a way to create “synergy”, that is, more
value by working together than if they were free-standing units. This chapter is divided into five major
sections:

1. We address how related diversification can enable a firm to benefit from horizontal
relationships across different businesses in the corporate family. Here, firms can attain
economies of scope through either leveraging core competencies or sharing activities
(such as production facilities or distribution facilities).

2. We discuss how firms can benefit from related diversification through greater market power.
Here, we address pooled negotiating power and vertical integration.

3. The third section discusses how firms can benefit from unrelated diversification. There are
two key means to this end: Corporate parenting and restructuring as well as portfolio
management.

4. The fourth section focuses on the means that firms can use to achieve diversification. The
means include mergers and acquisitions; strategic alliances and joint ventures; and
internal development. We discuss the advantages and disadvantages associated with each
of these.

5. The fifth section addresses the practical implications of real options theory (ROA). ROA has
been found to be a useful tool to help managers with resource allocation decisions.

6. We close the chapter with a section on how managerial motives can erode value creation as
firms pursue diversification initiatives. These include growth for growth’s sake, egotism,
and anti-takeover tactics (e.g., greenmail, poison pills).

Transparency 51 (Learning Objectives)

LECTURE/DISCUSSION OUTLINE
The introductory case for this chapter is Charles Schwab and Company, one of the largest
discount brokers. The case focuses on how the firm was able to grow successfully until it veered away
from its primary competency—serving the cost-conscious investor. That is, when it ventured into
servicing wealthy investors and did not carefully analyze its acquisition target, its performance eroded.

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 Why did Schwab’s performance significantly erode after the U.S. Trust acquisition?
Could this acquisition have been successful for Schwab? Why? Why not?

 Do you know of other companies that made similar types of mistakes? What were
the implications?

We next point out that Charles Schwab and Company’s failure at diversification is hardly unique.
Rather, many diversification efforts do not lead to the intended results.

STRATEGY SPOTLIGHT 6.1 provides an interesting perspective on the extent of mergers and
acquisitions in the United States in recent years and some of the reasons for their poor performance.

Clearly, STRATEGY SPOTLIGHT 6.1 is used to reinforce the point that most diversification
efforts fail. Thus, “making it work” becomes a real challenge for strategic managers. A summary
question would be:

 Why do most diversification efforts fail?

The SUPPLEMENT below points out that many times diversification efforts fail for strictly
personal reasons such as incompatibilities among managers in different businesses under the corporate
umbrella. Thus, it’s not only a matter of formulating the best strategies but also making sure strategies are
properly implemented.

FAILED DIVERSIFICATION EFFORTS: SOMETIMES IT’S JUST PERSONALITIES

In one company, the CEO tried for five years to get the managers responsible for European and North American
operations to collaborate. A headstrong young woman with a strong belief in an open management style ran the
North American business. On the other hand, a traditional Englishman who preferred to operate through formal,
hierarchical structures led the European unit. Both managers privately aspired to head the entire global business, but
publicly they argued that there were few overlaps between their businesses that would merit cooperation. After a
series of failed attempts to get the businesses to work together, each of which ended in bitter rows and
recriminations, the CEO finally lost patience and fired both managers. In their places, he appointed managers who
were more compatible and they enjoyed a great deal of success.

Source: Goold, M. & Campbell, A. 1998. Desperately seeking synergy. Harvard Business Review, 76(5): 140.

Some general questions to spur discussion and debate:

 How can such cooperation problems be reduced or eliminated?

 How prevalent do you think they are in business practice?

A. MAKING DIVERSIFICATION WORK: SOME KEY ISSUES

At the end of the day, diversification initiatives—whether via mergers and acquisitions, strategic
alliances and joint ventures, or internal development—must be justified by the creation of value for
shareholders. Firms can either diversify into related or unrelated businesses.

With related diversification, the primary benefits are to be derived from horizontal relationships
—businesses sharing intangible resources (i.e., core competencies) and tangible resources (e.g.,

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production facilities, distribution channels). For example, Proctor & Gamble enjoys many synergies from
having multiple businesses that share distribution resources.

With unrelated diversification, the primary benefits are derived largely from vertical
relationships, that is, value that is created by the corporate office. This would include infrastructure
activities such as information systems and corporate culture/leadership, sound businesses practices that
have been honed by the corporation over time, and human resource practices. Tyco International, a firm
we discuss in the chapter, has successfully followed this strategy. Key among its reasons for success are
exceptional human resource practices and reward systems.

EXHIBIT 6.1 provides an overview of how we will address the various means by which firms
create value through both related and unrelated diversification. The exhibit also includes an overview of
some of the examples that we have in this chapter.

Transparency 52 (Ex. 6.1) Creating Value Through…

The SUPPLEMENT below addresses perspectives by two well-known CEOs on cultural issues
that arise in diversification initiatives.

CULTURAL ISSUES IN DIVERSIFICATION INITIATIVES

The following are excerpts from statements made by two well-known executives on how cultural issues can affect
diversification initiatives:

Bill Avery (CEO: Crown, Cork, and Seal) “… having just acquired a European company, I can tell you that there is
one cultural difference still very fresh in my mind. Let’s say you’re not making your budgets because the selling
prices of your products are falling. In the U.S., we’d think, ‘Well, if prices are going down, we’ve got to cut costs.’
But in Europe, some managers may be inclined to say, ‘Well, prices are falling now, but in a couple of years, they’ll
go back up.’ My experience at Crown has been that European management tends to be generally less aggressive in
cutting costs than we are here in the U. S., perhaps because margins traditionally have been higher in Europe. That’s
a really big culture clash.”

Ed Liddy (CEO: Allstate Insurance) “It’s important to remember that you don’t always have to have a high degree
of cultural integration. You can’t slam every acquisition into one mold. In the last 12 to 15 months, we’ve probably
made four or five acquisitions. In some cases, we’ve completely integrated them into Allstate. But in other cases,
much to the chagrin of our very good Allstate executives, I’ve said, ‘I don’t want you to ‘Allstate-ize’ them. I want
them to be separate.’ In the end, what you do with an acquisition depends on the channels and the products that you
and the acquired company are in.”

Source: Carey, D. (Moderator). 2000. A CEO roundtable on making mergers succeed. Harvard Business Review, 78
(3): 151-152.

I. RELATED DIVERSIFICATION: ECONOMIES OF SCOPE AND

REVENUE ENHANCEMENT
Related diversification enables a firm to benefit from horizontal relationships across different
businesses in the diversified corporation. There are two means for accomplishing this: (1) leveraging
core competencies, and (2) sharing activities.

Such horizontal relationships across businesses enable the corporation to benefit from economies
of scope which refers to cost savings due to the breadth of operations. Additionally, a firm can enjoy

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 greater revenues if two businesses attain higher levels of sales growth combined than either business
could independently.

The SUPPLEMENT below provides the example of Blue Circle Industries—a firm whose
diversification strategy failed because it improperly failed to identify core competencies and opportunities
for sharing activities.

BLUE CIRCLE INDUSTRIES: A FAILED DIVERSIFICATION STRATEGY

Blue Circle Industries, a British company, is one of the world’s leading cement producers. In the 1980s, Blue Circle
decided to diversify on the basis of an unclear definition of its business. It was, the company’s managers
determined, in the business of making products related to home building. So Blue Circle expanded into real estate,
bricks, waste management, gas stoves, and bathtubs—even lawn mowers. According to one retired executive, “Our
move into lawn mowers was based on the logic that you need a lawn mower for your garden—which after all, is
next to your house.” Not surprisingly, few of Blue Circle’s diversification efforts proved successful.

Source: Markides, C. C. 1997. To diversify or not to diversify. Harvard Business Review, 75 (6): 94.

a. LEVERAGING CORE COMPETENCIES

We begin with the imagery of a tree to illustrate the concept of core competencies. Core
competencies represent the root system (not the leaves) and competitors can make a big mistake if they
believe a firm’s strength is in their leaves (by analogy). Core competencies may be considered to be the
“glue” that binds existing businesses together or as the engine that fuels new business growth.

Core competencies—to create synergy for a corporation—must satisfy three conditions:

 The core competence must enhance competitive advantage(s) by creating superior

customer value. (Gillette)
 Different businesses in the corporation must be similar in at least one important way to
benefit from the core competence. (Harley Davidson)
 The core competencies must be difficult for competitors to imitate or find substitutes for
(3M).

The SUPPLEMENT below provides the example of 3M—a firm known for achieving synergies
from its technologies.

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 HOW 3M LEVERAGES ITS ADHESIVES TECHNOLOGY

Core competencies go beyond harmonizing streams of technology, integrating production flows, or coordinating
marketing and merchandising efforts. Value activities must be linked to deliver customer value in a timely manner.
Consider, for example, how 3M has leveraged its core competence in adhesives technologies to applications in a
wide variety of industries:

 In the telecommunications industry, adhesives bond optical fiber cables used in cable TV and
telephone networks. 3M’s hot-melt fiber optic connectors, which are faster and require fewer connections
than other splicing methods, blend 3M’s expertise in advanced adhesives, ceramics, and fiber optics.
 The automotive industry uses 3M adhesives to replace more expensive and time-consuming
fastening technologies, including rivets and welding.
 In the aerospace industry, Scotch-Weld structural adhesives replace welding in the fabrication of
sound-suppression panels in aircraft engines, and adhesive-based sealants are used in airplane fuel tanks.

Source: 1993 3M Corporation Annual Report: Giglio, J. 1996, 3M Corporation, ValueLine, March 1: 1893.

Teaching tip: Although many companies have core competencies, not all seem to be able to leverage
them. You may ask students to speculate why so may firms fail to leverage their core competencies.
Possible reasons may include failure to recognize opportunities to leverage, lack of complementary
competencies, or problems with culture, structure, and reward systems within the organization. This
serves to reinforce the integrative nature of strategy formulation and implementation and the
interconnections among the various aspects of organizational strategies, structures, and systems.

b. SHARING ACTIVITIES

Synergy can also be achieved by sharing tangible activities across business units. These include
value-creating activities such as common manufacturing facilities, distribution channels, and sales forces.

Sharing activities provide two potential benefits: cost savings and revenue enhancements.

1. DERIVING COST SAVINGS THROUGH SHARING ACTIVITIES

Cost savings come from many sources such as eliminating jobs, facilities, and related expenses
that are no longer needed when functions are consolidated. We provide the example of Shaw Industries, a
leading player in the carpet industry.

2. ENHANCING REVENUE AND DIFFERENTIATION THROUGH SHARING

ACTIVITIES

At times, an acquiring firm and its target may attain a higher level of sales growth together than
either company could do on its own. We provide the example of Gillette’s acquisition of Duracell
(batteries).

Firms can also increase the effectiveness of their differentiation strategies via sharing activities
among business units. We discuss VF’s acquisition of Nutmeg Industries and H. H. Cutler.

STRATEGY SPOTLIGHT 6.2 discusses how Walt Disney Company leverages its core
competencies and shares activities across many business units.

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II. RELATED DIVERSIFICATION: MARKET POWER
Here, we address two principal means by which firms attain synergy through market power:
pooled negotiating power and vertical integration. Note that managers have limits on their ability to use
market power for diversification—government regulations can sometimes restrict the ability of a business
to gain very large shares of a particular market. (We provide examples from the American Online (AOL)
and Time Warner merger that was approved with conditions that required the merged entity to provide
competitors market access. Also, we discuss why the attempted acquisition of Honeywell by General
Electric was foiled by the European Commission (EC)).

A. POOLED NEGOTIATING POWER

Similar businesses working together or the affiliation of a business with a strong parent can
strengthen an organization’s bargaining power in relation to suppliers and customers as well as enhance
its position vis a vis its competitors. We provide the comparison of an independent food producer with
the situation in which the same business is part of a giant player such as Nestle.

Consolidating an industry can also increase a firm’s market power. In addition to the AOL Time
Warner merger, we give the example of the Tribune Corporation’s (owner of the Chicago Tribune and
WGN-TV) $8 billion acquisition of The Times Mirror Company.

We also note that managers must evaluate how the combined business may affect relationships
with actual or potential competitors, suppliers, and customers. We give the example of how PepsiCo was
unable to entice McDonald’s as a customer since they had (until recently) competing business units (KFC,
Taco Bell, and Pizza Hut).

The SUPPLEMENT below addresses how IBM’s acquisition of PricewaterhouseCoopers

Consulting should increase the firm’s market power. It consists of excerpts from Ginni Rometty, General
Manager, IBM Consulting Services.

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 IBM: CREATING MARKET POWER VIA THE ACQUISITION
OF THE PRICEWATERHOUSECOOOPERS CONSULTING UNIT

In October, 2002, IBM completed the acquisition of PricewaterhouseCoopers Consulting for a price of $3.5 billion
in cash and stock. This created the world’s largest consulting-services company. The merger, which involves
60,000 employees based in more than 160 countries, is an aggressive move by IBM to enhance its position in the
technology-services industry as well as become one of the world’s leading professional-services companies. In
charge of this initiative is Ginni Rometty, general manager, a 20-year IBM veteran and founding member of its
business-and-IT consulting division.

Below are some of her insights on the acquisition:

“We have a wonderful complementary set of industry process skills. IBM had built strong technology services, a
global applications business, and strength in outsourcing. PwC built business-advisory services, application skills,
and process skills. This isn’t about making them stronger. We’re creating something new together—a new category
of service for clients that’s completely end to end…

“I want to build an image of IBM as a business-services partner that’s as strong as our image as a technology-
services partner. We want to bring more value to clients, deliver bottom-line business value, and bring about
business change at the same time as technology change. The services marketplace is very fragmented. But the goal
is to gain increasing share in the professional-services market.”

Source: Overholt, A. 2003. In the hot seat. Fast Company, January: 46.

B. VERTICAL INTEGRATION

Vertical integration represents an expansion or extension of the firm by integrating preceding or

successive productive processes. That is, the firm incorporates more processes toward the original source
of raw materials (backward integration) or toward the ultimate consumer (forward integration).
STRATEGY SPOTLIGHT 6.3 provides the example of Shaw Industries (the carpet producer) that has
engaged in both backward integration (i.e., acquiring fiber manufacturing facilities) as well as forward
integration (i.e., acquiring floor covering retailers).

EXHIBIT 6.2 illustrates the stages of vertical integration for Shaw Industries.

Transparency 53 (Ex. 6.2) Simplified Stages of Vertical Integration…

We address the benefits and risks of vertical integration. They are summarized in EXHIBIT 6.3.

Transparency 53 (Ex. 6.3) Benefits and Risks of Vertical Integration…

The SUPPLEMENT below discusses how Tosco, a petroleum refiner, was able to enhance its
competitive and financial position by integrating forward into service stations and convenience stores.

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 TOSCO’S SUCCESSFUL STRATEGY OF FORWARD INTEGRATION

Tosco, which for decades focused exclusively on petroleum refining, dramatically improved its fortunes through
forward vertical integration. In the early 1990s, the Stamford, Connecticut-based company became concerned about
the low growth for refined oil. It also determined that gasoline service stations had access to more profitable, non-
gas products, such as cigarettes and soft drinks. So it moved into a new segment of the value chain by acquiring
retail assets (service stations) at depressed prices, first from British Petroleum and then from Exxon.

In 1995, Tosco raised the ante by acquiring the convenience store chain Circle K. This gave it a critical mass of
stores and service stations with strong brands that it consolidated under Circle K management. The 5,000-store
network operates as a profit center with its own headquarters, which is distinct from the refining business. Retail
managers focus on the more profitable consumer and ancillary businesses, with gasoline sales viewed primarily as a
traffic generator. Tosco has become the largest independent refiner and retailer in the United States and over a
recent five year period has achieved a combined annual growth rate in market value of 58 percent!

Source: Slywotzky, A. J., Mundt, K. A. & Quella, J. A. 1999. Pattern thinking. Management Review, June: 34.

In making decisions associated with vertical integration, four issues need to be considered:

 Are we satisfied with the quality of the value that our present suppliers and distributors
are providing?
 Are there activities in our industry value chain that are presently being performed by
others independently that are viable sources of profits?
 Is there a level of stability in the demand for the organization’s products?
 What is the proportion of additional production capacity that is actually absorbed by
existing products or by the prospects of new and similar products?

We note the importance of recognizing the difficulties in executing vertical integration strategies.
Two examples include Unocal (in contrast to the above SUPPLEMENT—Tosco’s success in the same
endeavor) and Eli Lilly’s failure at forward integration endeavors (e.g., acquiring a pharmaceutical mail
order business).

We discuss how vertical integration can be analyzed from the transaction cost perspective.

We close this section with STRATEGY SPOTLIGHT 6.3 that discusses how Proctor & Gamble
was able to strengthen its competitive position through all four means of horizontal relationships that we
have discussed.

III. UNRELATED DIVERSIFICATION: FINANCIAL SYNERGIES AND

PARENTING
We now address unrelated diversification. Here, unlike related diversification, there are few
benefits to be derived from horizontal relationships, that is, the leveraging of core competencies or the
sharing of activities across business units in a corporation.

In unrelated diversification, the benefits are to be gained from vertical (or hierarchical)
relationships, i.e., the creation of synergies from the interaction of the corporate office with the individual
business units. There are two main sources of such synergies:

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  the corporate office can contribute to “parenting” and restructuring of (often acquired)
businesses, and
 the corporate office can add value by viewing the entire corporation as a family or
“portfolio” of businesses and allocating resources to optimize corporate goals of
profitability, cash flow, and growth.

A. CORPORATE PARENTING AND RESTRUCTURING

The positive contribution of the corporate office has been referred to as the “parenting
advantage”. Many parent companies such as BTR, Emerson Electric, and Hanson create value through
management expertise. We provide the example of Cooper Industries, whose parenting approach is used
to improve the performance of the acquired firms manufacturing operations; cost accounting systems; and
planning, budgeting and human resource systems.

Restructuring is another means by which the corporate office can add substantial value to a
business. Here, the corporate office tries to find either poorly performing firms with unrealized potential
or firms in industries on the threshold of significant, positive change. We address three types of
restructuring: Asset Restructuring, Capital Restructuring, and Management Restructuring.

For restructuring strategies to work, corporate management must have both the insight to detect
undervalued companies (otherwise the cost of acquisition would be too high) or businesses competing in
industries with high potential for transformation. Also, they must have the requisite skills and resources
for turning the businesses around—even if they are new and unfamiliar businesses.

We provide the example of Hanson plc, a British conglomerate, and how they have successfully
grown via an acquisition strategy into unrelated areas.

B. PORTFOLIO MANAGEMENT

Here, the key concept is the idea of a balanced portfolio of businesses. This consists of
businesses whose profitability, growth, and cash flow characteristics would complement each other, and
add up to satisfactory overall corporate performance.

The Boston Consulting Group’s growth/share matrix is among the best known of these
approaches. Each of the firm’s strategic business units (SBUs) is plotted on a two-dimensional grid, in
which the axes are relative market share and industry growth rate. EXHIBIT 6.4 illustrates the BCG
matrix.

Transparency 55 (Ex. 6.4) The BCG Portfolio Matrix

In using a portfolio strategy approach, a corporation tries to create synergies and shareholder
value in a number of ways. Since the businesses are unrelated, synergies that develop are the result of the
actions of the corporate office interacting with the individual units, i.e., vertical relationships, instead of
across business units, i.e., horizontal relationships.

 What are the main advantages of portfolio approaches? (e.g., provide good snapshot
to help allocate resources, helps determine attractiveness of acquisitions, can provide funds
to business units at favorable rates, corporate office can provide high quality review of

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 business units, and, provides a basis for developing strategic goals and reward and
evaluation systems)

We discuss Ciba-Geigy (now Novartis) to show how firms can benefit from portfolio approaches.

The SUPPLEMENT below provides another example—Proctor & Gamble—of portfolio analysis.

THE USE OF PORTFOLIO MANAGEMENT AT PROCTOR & GAMBLE

The following is excerpted from a presentation: “Remarks to Financial Analysts” by A. G. Lafley, President and
CEO and C. Daley, CFO of Proctor & Gamble Company on September 28, 2000 in New York City:

“As to where to invest for future growth, that requires an assessment of our portfolio. I’m not ready to talk about
portfolio decisions, but I can share the process, the criteria, and the timetable.

“I am personally evaluating the industry attractiveness of all the business categories we currently play in. I’m
comparing industry attractiveness to P&G capabilities and financial goals.

“Within each industry, I’m reviewing the strategy, business health and financial performance of the best-performing
company—whether P&G or a competitor.

“If a competitor, I’m comparing P & G’s performance to that competitor and to industry average performance. This
is the first important step—facing up to current reality, understanding how P&G is really performing, and who’s
winning today.

“In business categories where we are the leader and setting the performance benchmark, I’m focusing on strategy
that will widen our margin of leadership.

“In business categories where we are currently a strong number two, I am asking for a strategy and plans to become
the leader, and to perform at least as well, and ideally better, than the current best competitor.

“In business categories where we are not the leader and only delivering average returns, I’m asking how we’re going
to get better-than-average industry returns fast.

“Finally, in businesses where we’re struggling and under-performing, I’m asking for a “Fix-It-Fast” plan or an
alternative resolution. I’ll have little patience for these.”

 What do you think are some of the benefits (drawbacks) of this approach?

We then provide some of the disadvantages of portfolio approaches such as the BCG matrix.

 What are the primary limitations of portfolio approaches? (too simplistic—only two
dimensions, ignores potential synergies across businesses, process can become too
mechanical, may rely on overly strict rules to allocate resources, and, the imagery may lead
to overly simplistic prescriptions)

We close out the section with the example of how a corporation, Cabot Corporation, experienced
erosion in its market position when it “blindly” adopted the portfolio approach.

C. CAVEAT: IS RISK REDUCTION A VIABLE GOAL OF DIVERSIFICATION?

In this section we briefly address the issue as to whether or not diversification should be
undertaken in order to reduce risk that is inherent in a firm’s variability in revenues and profits over time.

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While it may make sense at “first glance”, there are some limitations to such an approach. First, a firm’s
stockholders can diversify their portfolio at much lower cost than a corporation. And, second, economic
cycles as well as their impact on a given industry (or firm) are very difficult to predict with any degree of
accuracy.

However, such a diversification rationale can, at times, be justified. We discuss how Emerson
Electric has benefited from diversification by lowering the variability (or risk) in their performance over
time.

The SUPPLEMENT below addresses one of the benefits of an unrelated diversification strategy
that is becoming more popular—tax advantages. As noted in the example below of Marriott International,
it can dramatically increase a firm’s net income.

REDUCING A FIRM’S TAX LIABILITIES:

THE JUDICIOUS USE OF UNRELATED DIVERSIFICATION INITIATIVES

Although Marriott International is well-known for their plush hotels, they have a sizable investment in one area that
few would expect: coal-treatment machinery!

Why? Coal-scrubbing machines don’t appear to have many synergies with an elite hotelier, but the investment
serves a different profit center, one that has become increasingly important for Corporate America: tax
management, a euphemism for old-fashioned tax avoidance. Using tax credits stemming from a section of the tax
code meant to encourage production of fuel from nonconventional sources, last year Marriott recorded a net tax
benefit from the coal machines of $74 million. It expects a similar savings in 2003—in all, more than double its
initial $60 million investment. That bonus was the biggest factor in driving the company’s effective tax rate down to
6.8 percent, from 36.1 percent in 2001, as Marriot disclosed to shareholders. That tax boon accounted for more than
a quarter of last year’s $277 million in net income.

There’s nothing illegal about what Marriott is doing, and, in fact, nothing unusual. The federal income tax rate for
corporations is 35 percent, but few pay that much. Over the past decade, companies across the U. S. have
aggressively pursued tax-reduction strategies like Marriott’s. Many have achieved that Holy Grail of corporate
finance: steadily growing profits coupled with a dramatically shrinking tax burden. To reach that goal, they are
taking extraordinary steps—everything from making tax-favored investments to shifting profits to low-tax
jurisdictions overseas to reincorporating in Bermuda or other tax havens.

Source: Byrnes, N. & Lavelle, L. 2003. The corporate tax guide. BusinessWeek, March 31: 79.

IV. THE MEANS TO ACHIEVE DIVERSIFICATION

In the first three sections of the chapter we addressed the types of diversification (i.e., related and
unrelated). Now we address the means to attain diversification. These include:

 mergers and acquisitions

 strategic alliances and joint ventures
 internal development

A. MERGERS AND ACQUISITIONS

 What are the major advantages and disadvantages of mergers and acquisitions?

Growth through mergers and acquisitions (M&A) has played a critical role in the success of many
corporations in a wide variety of high technology and knowledge-intensive industries. Here, market and

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technology changes can occur very rapidly and unpredictably. In addition to speed, M&A can also be a
valuable means of obtaining resources that can help an organization to expand its product offerings and
services. M&A also can help companies enter new market segments. Exhibit 6.5 lists the ten largest
mergers and acquisitions in recent business history as well as the generally negative impact on
shareholder value.

Transparency 56 (Ex. 6.5) The Top Mergers

As one would expect, there are also some potential downsides to M&A endeavors. These include
the expensive premiums that are often paid to acquire a business, difficulties in integrating the activities
and resources of the acquired firm into the corporation’s operations, and competitors may quickly imitate
“synergies”.

We provide the quotation from Joanne Lawrence, a VP at SmithKline Beecham (now Glaxo
SmithKline) regarding cultural issues that may foil M&A activities.

We close with STRATEGY SPOTLIGHT 6.5 that highlights the problems that Stephen Covey’s
firm experienced when the Franklin Quest Company acquired them. This example may be particularly
interesting to students—given Covey’s fame and wealth that is associated with The Seven Habits of
Highly Effective People. Exhibit 6.7 Summaries this ineffective merger.

Transparency 57 (Ex. 6.7) The Seven Habits…

 Do you think these problems could/should have been anticipated?

 How could these issues be resolved?

B. STRATEGIC ALLIANCES AND JOINT VENTURES

 What are the major advantages and limitations of strategic alliances and joint
ventures?

Strategic alliances and joint ventures are assuming an increasingly prominent role in the strategy
of leading firms, both large and small. Such cooperative relationships have many potential advantages.
Among these are (our text examples are included):

 entry into new markets (the partnership of Time-Warner and three black-owned cable
companies in New York City)
 reducing manufacturing (or other) costs in the value chain (Molson Companies and
Carling O’Keefe breweries)
 developing and diffusing new technologies (STM Microelectronics’s alliances with many
of their high-tech customers)

The SUPPLEMENT below discusses the joint venture formed by Advanced Micro Devices and
Fujitsu to produce flash memory chips. The joint venture is expected to be a vehicle for reducing
manufacturing costs as well as developing new technologies.

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 ADVANCED MICRO DEVICES (AMD) AND FUJITSU
FORM A JOINT VENTURE TO MAKE FLASH MEMORY CHIPS

Faced with the challenges of heavy pricing pressure as well as higher manufacturing costs, semiconductor maker
AMD will combine its flash memory chip operations with rival Fujitsu. The two firms will share costs on research
and development, marketing, and other expenses. AMD and Fujitsu have been operating under a joint
manufacturing venture to produce the chips, which store data in cell phones and handhelds even when the devices
are turned off. Their new company, called FASL, will have operations around the world, with 7,000 employees in
all. It will be headquartered in Sunnyvale, California.

Source: Roman, M. (Ed.). 2003. AMD and Fujitsu make memories. BusinessWeek, April 14: 43.

There are also many potential limitations associated with strategic alliances and joint ventures.
Problems often arise when there are not complementary strengths, limited opportunities for developing
synergies, low trust among the partners, and minimal attention given to nurturing close working
relationships.

STRATEGY SPOTLIGHT 6.6 discusses a recent joint venture between Proctor & Gamble and
Coca-Cola Company.

The SUPPLEMENT below addresses some useful tips for making partnerships work.

TIPS FOR MAKING PARTNERSHIPS WORK

Here is what some experts advise for successful partnerships:

1. Demonstrate the value of your partnership to gain your partner’s confidence. Your partner will then be
much more open to your ideas.

2. Establish rules of engagement with your partner, including boundaries and responsibilities, early.

3. Focus on your partner’s best interests. Avoid becoming too revenue-focused when partnering.

4. Find partners with skills that complement—not rival—your own.

5. Respect your partners.

6. Watch out for hidden agendas, such as a partner looking to tap into your expertise so it can get an
upper hand going forward.

7. If the cultural shoe fits, wear it. Find partners with perspective and methodologies that mirror your
own.

Source: Cirillo, R. 2000. Joining forces. VARBusiness. October 2: 52-53.

 What would be some of the negative consequences if these “tips” were not followed?

C. INTERNAL DEVELOPMENT

Firms can also diversify via corporate entrepreneurship and new venture development. In today’s
economy, internal development (or intrapreneurship) is such an important topic by which companies

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expand their businesses that we dedicate a major portion of an entire chapter to it (Chapter 12—which
also addresses entrepreneurship).

We give the examples of 3M as well as Rosa Verde, a small but growing business serving the
health care needs of San Antonio, Texas.

Among the advantages of internal development is the ability to capture all of the value of
innovative endeavors (as opposed to sharing with partners). Generally firms may be able to accomplish it
at a lower cost than relying on external funding. There are also potential disadvantages such as the time
consuming nature of intrapreneurship—which is particularly important in fast-changing competitive
environments.

The SUPPLEMENT below addresses how Ford Motor Company was able to develop one of the
industry’s most progressive websites. Before discussing this example, it may be useful to ask:

 How can internal development endeavors be made more effective?

FORD’S PROGRESSIVE WEBSITE

In 1997, Thor Ibsen became Ford’s first full-time Internet sales-and-marketing strategist. Now, he has a 100-
member team and has established ford.com as one of the auto industry’s best websites. He argues, “We are
constantly thinking about how to combine the best of both worlds—the flexibility of the Net and the power of Ford
Motor Company.” Here’s his advice on running an Internet initiative within a large organization:

Balance outsiders with insiders. Ibsen made sure that his team included both Net-savvy outsiders and well-
connected Ford insiders. The outsiders would push the team toward technology solutions and new business models.
The insiders, meanwhile, would give the team credibility within Ford.

Hire only people who are comfortable with change. When hiring inside Ford, Ibsen and his colleagues look for
candidates who are risk takers and have a vision for change.

Don’t get busted with budgets. Working with the finance organization, Ibsen established a rolling budget plan for
his group, which means that although he doesn’t have access to an infinite sum of money, he can decide throughout
the year how he wants to spend the resources that he does have.

Avoid battles over status. When two executives who are close in status discuss an initiative, Ibsen believes that it
often devolves into a face-off. His solution: “We don’t like face-offs. So we send a less-senior person who’s not in
the running to be sheriff.”

Campaign at every level. Although high-level backers are important, Ibsen says, “If you don’t get support from the
working lieutenants and line managers, you won’t be able to deliver on your projects, and then your top-level
support will quickly vaporize.”

Source: Kisner, S. 2000. How Ford.com gets in gear. Fast Company. January-February: 128.

STRATEGY SPOTLIGHT 6.6 discusses Wal-Mart’s recent strategic alliance with the Asbury
Automotive Group to sell used cars.

 Do you think this strategic alliance will succeed? Why? Why not?

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V. REAL OPTIONS ANALYSIS: A USEFUL TOOL

This section discusses the practical implications of real options analysis (ROA) as a tool that has
been adopted by executives and consultants to support the strategic decision-making in firms. The term
“real options” applies to situations where option theory and valuation techniques are applied to real assets
or physical things, in contrast to financial assets.

The concepts of options can be applied to strategic decisions to give management flexibility. That
is, it enables management to decide whether or not to invest additional funds to grow or accelerate an
activity, delay perhaps to learn more, shrink the scale of the activity, or abandon it altogether. This aspect
makes ROA attractive because firms can have the prospect of high gains with relatively little upfront
investments that represent limited losses.

STRATEGY SPOTLIGHT 6.7 provides two examples of ROA to guide the decision process. The
two companies are a privately-held biotechnology firm and Merck, the giant pharmaceutical firm.

Teaching Tip: To illustrate the rather abstract concept of Real Options, you may ask students why
companies provide business students with internships. You may probably give many answers that
include reasons such as improved public relations, meet short-term staffing needs, or trying out the
candidate to see whether full-time employment will be later offered. The latter option is, of course, an
application of real options theory. That is, the firm is writing an option on the individual and can later
either kill the option (i.e., terminate the employment relationship) or exercise the option by hiring the
individual on a full-time basis. In this manner, the firm may benefit from a long-term benefit while
risking only a short-term investment.

VI. HOW MANAGERIAL MOTIVES CAN ERODE VALUE CREATION

In this section, we address some of the managerial motives that can erode, rather than enhance,
value creation. These include “growth for growth’s sake”, excessive egotism, and the creation of a wide
variety of anti-takeover tactics.

A. GROWTH FOR GROWTH’S SAKE

There are huge incentives for executives to grow the size of the firm. These include extra
prestige (such as higher rankings in the Fortune 500) and compensation as well as the excitement that is
generated by making the “big play.”

We provide the examples of Priceline.com’s entry into offering groceries and gasoline online, and
how Joseph Bernardino’s overemphasis on growth at Andersen Worldwide played a key role in the firm’s
demise. Both of these efforts of growth had negative implications for their firms’ viability.

The SUPPLEMENT below discusses Service Corporation’s (a funeral home and cemetery
services provider) overly ambitious growth strategy—and dismal performance.

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 SERVICE CORPORATION’S FAILED GROWTH STRATEGY

Service Corporation is the largest such company in the United States. It gained this distinction through aggressive
acquisitions. Starting as a single funeral home, the firm has grown to 3,823 funeral homes and 524 cemeteries. The
result: Service Corporation was the second worst performing stock in the S&P 500 in 2000.

This apparent contradiction—high growth and low stock performance—has Service Corporation executives
concerned. Accordingly, they have stopped growth through acquisitions and have begun to focus on turning around
the company through restructuring. Its emphasis is now being placed on tight control of costs as well as on offering
new product bundles to increase market share and profitability.

By bundling services such as funeral services, cemetery plots, grief counseling and estate planning, the firm hopes to
attract customers. Service Corporation positions its services as a low-cost, one-stop package. By bundling services,
the overall cost is lower for the customer but increases the volume of sales for the company.

As a cost containment measure, the firm has cut over 1,100 jobs and reorganized its structure to save $35-40 million
annually. They have stopped paying dividends—a savings of $97 million—choosing instead to invest in internal
growth. Despite these actions, the firm took a $312 million charge resulting from its restructuring and had a net loss
of $184.2 million in 2000.

Sources: Hassell, G. 2001. Funeral chain Service Corporation finds cutting back is the way to rebuild. Lexington
Herald-Leader, February 19: 13; and Anonymous. 2001. Service Corporation profit gains, reduces debt by 8
percent. Reuters, May 9: np.

B. EGOTISM

As we all know, a healthy ego makes a leader more confident and able to cope with change.
However, sometimes pride is at stake, and individuals will go to great lengths to win—or at least not back
down. Such behavior is often detrimental to the firm.

We provide the example of the rather hostile interaction between Warner Brothers and a Time Inc.
executive after their merger. Such clashes can certainly lead to the erosion of some of the intended
benefits of diversification. We also discuss “lessons learned” by GE’s Jack Welch—situations in which
ego got in the way of better judgment.

We also discuss how egotism (as well as very poor judgment!) led to the demise of Tyco
International’s Dennis Kozlowski and Vivendi Universal’s Jean-Marie Messier.

 How can such egotistic behavior be minimized? (e.g., reward and control systems,
executive selection, culture, etc.)

C. ANTI-TAKEOVER TACTICS

Anti-takeover tactics are rather common. These are efforts by management to prevent hostile or
unfriendly takeovers by unwelcome suitors. Often, it is in management’s best interests to undertake such
actions—but typically not in the interests of the firm’s shareholders.

We discuss three types of anti-takeover tactics: greenmail, golden parachutes, and poison pill.

STRATEGY SPOTLIGHT 6.8 illustrates poison pill anti-takeover provisions. These are the
means by which a company can give shareholders certain rights in the event of a takeover by another

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firm. In addition to “poison pills”, they are also known as shareholder rights plans. Clearly, such anti-
takeover tactics can raise some interesting ethical issues.

Teaching Tip: Ask the students how the managerial behaviors that erode shareholder value can be
minimized. This provides you with an opportunity to reintroduce the underlying concepts of corporate
governance that we introduced in Chapter 1 and will be discussed at length in Chapter 9. The core
elements of corporate governance are a committed and well-informed board of directors, shareholder
activism, and effective incentive and reward systems for executive officers.

VII. SUMMARY
A key challenge of today’s managers is to create “synergy” when engaging in diversification
activities. As we discussed in this chapter, corporate managers do not, in general, have a very good track
record in creating value in such endeavors when it comes to mergers and acquisitions. Among the factors
that serve to erode shareholder values are paying an excessive premium for the target firm, failing to
integrate the activities of the newly acquired businesses into the corporate family, and undertaking
diversification initiatives that are too easily imitated by the competition.

We addressed two major types of corporate-level strategy: related and unrelated diversification.
With related diversification the corporation strives to enter into areas in which key resources and
capabilities of the corporation can be shared and leveraged. Synergies come from horizontal relationships
among business units. Cost savings and enhanced revenues can be derived from two major sources.
First, economies of scope can be achieved from the leveraging of core competencies and sharing of
activities. Second, market power can be attained from greater, or pooled, negotiating power and from
vertical integration.

When firms undergo unrelated diversification they enter product-markets that are dissimilar to
their present businesses. Thus, there is generally little opportunity to either leverage core competencies or
share activities across business units. Here, synergies are created from vertical relationships between the
corporate office and the individual business units. With unrelated diversification, the primary ways to
create value are corporate restructuring and parenting, as well as the use of portfolio analysis techniques.

Corporations have three primary means of diversifying their product-markets. These are mergers
and acquisitions, joint ventures/strategic alliances, and internal development. There are key tradeoffs
associated with each of these. For example, mergers and acquisitions are typically the quickest means to
enter new markets and provide the corporation with a high level of control over the acquired business.
However, with the expensive premiums that often need to be paid to shareholders of the target firm and
the challenges associated with integrating acquisitions, they can also be quite expensive. Strategic
alliances among two or more firms, on the other hand, may be a means of reducing risk since they involve
the sharing and combining of resources. But such joint initiatives also provide a firm with less control
(than it would have with an acquisition) since governance is shared between two independent entities.
Also, there is a limit to the potential “upside” for each partner because returns must be shared as well.
Finally, with internal development, a firm is able to capture all of the value from its initiatives (as
opposed to sharing it with a merger or alliance partner). However, diversification by means of internal
development can be very time-consuming—a disadvantage that becomes even more important in fast-
paced competitive environments.

Traditional tools such as Net Present Value (NPV) are not always very helpful in making resource
allocation decisions under uncertainty. Real options analysis (ROA) is increasingly used to make better
quality decisions in such situations.

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 Finally, some managerial behaviors may serve to erode shareholder returns. Among these are
“growth for growth’s sake”, egotism, and anti-takeover tactics. As we discussed, some of these issues—
particularly anti-takeover tactics—raise ethical considerations because the managers of the firm are often
not acting in the best interests of the shareholders.

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