Chapter 6 Corporate-Level Strategy

Corporate-Level Strategy and Its Purpose

• A corporate-level strategy specifies actions a firm takes to gain a competitive advantage by selecting and managing a group of different businesses competing in different product markets.
• Purpose:
  • Helps firms diversify their operations from a single business in a single market into several product markets and businesses.
  • Helps companies select new strategic positions to increase the firm’s value.
  • Is expected to help the firm earn above-average returns by creating value for stakeholders.
• Two key issues a corporate-level strategy is concerned with:
  1. In what product markets and businesses the firm should compete.
  2. How corporate headquarters should manage those businesses.
• A firm can have multiple business-level strategies within its portfolio of businesses.
• An effective corporate-level strategy creates aggregate returns across all businesses that exceed what those returns would be without the strategy, contributing to strategic competitiveness and earning above-average returns.
• Product Diversification Concerns:
  • The scope of the markets and industries in which the firm competes.
  • How managers buy, create, and sell different businesses to align skills and strengths with opportunities.
• Diversification Success:
  • Reduces variability in the firm’s profitability as earnings are generated from different businesses.
  • Provides firms with the flexibility to shift investments to markets with the greatest returns, reducing dependence on one or a few markets.

Levels of Diversification Through Corporate-Level Strategies

• Diversified firms vary by their level of diversification and the connections among their businesses.
• There are five categories of businesses based on increasing levels of diversification:
  • Single business
  • Dominant business
  • Related constrained
  • Related linked
  • Unrelated

Low Levels of Diversification

• Single-business diversification strategy: The firm generates 95 \% or more of its sales revenue from its core business area.
• Dominant-business diversification strategy: The firm generates between 70 \% and 95 \% of its total revenue within a single business area. This reflects a small amount of diversification compared to related constrained strategies.

Moderate and High Levels of Diversification

• Related diversification strategy: A firm uses this when it generates more than 30 \% of its revenue outside a dominant business, and its businesses are related.
  • Related constrained diversification strategy:
    • Links between businesses use similar sourcing, throughput, and outbound processes.
    • A related constrained firm shares resources and activities across its businesses.
  • Related linked diversification strategy:
    • The firm’s portfolio of businesses has only a few links between them.
    • A related linked firm focuses on transferring knowledge and core competencies among its businesses.
• Unrelated diversification strategy:
  • A highly diversified firm with no relationships between its businesses.
  • Commonly, firms using this strategy are called conglomerates.
  • Unrelated firms make no effort to share activities or transfer core competencies between or among their businesses.

Reasons for Diversification

• The broad objective is to increase the firm’s value by improving its overall performance.
• Value is created when a corporate-level strategy helps the firm improve business-level strategies, either by increasing revenues or reducing costs.
• Synergies can be pursued by sharing tangible or intangible resources across business units.
• Synergy: Exists when the value created by business units working together exceeds the value they create independently.
  • This synergy comes from economies of scope, which are economic factors leading to cost savings by successfully sharing resources and capabilities or transferring corporate-level core competencies from one business to another.

Value-Creating Diversification

• Economies of Scope (Related Diversification):
  • Sharing activities.
  • Transferring core competencies.
• Market Power (Related Diversification):
  • Blocking competitors through multipoint competition.
  • Vertical integration.
• Financial Economies (Unrelated Diversification):
  • Efficient internal capital allocation.
  • Business restructuring.

How Diversification Increases Market Power

• Reducing costs below competitors' levels or increasing the firm’s ability to charge higher prices.
• Backward vertical integration: Producing inputs for its value creation system that were previously bought from other companies.
• Forward vertical integration: Becoming its own customer for some of its products or services.

Other Ways Diversification Can Increase Value

• Allocating capital and other resources to business units that need them most to stay competitive or to the highest-performing units, providing high returns on investment.
• Strategic Adaptations:
  • Adapting to changes in the external environment.
  • Responding to low performance.
  • Addressing uncertain cash flows.

Value-Creating Diversification: Related Constrained and Related Linked Diversification

• Both operational relatedness and corporate relatedness can create value.
• Firms seek to create value from economies of scope through two basic kinds of operational economies:
  1. Operational relatedness: Provides opportunities to share resources among the operational activities of the firm.
  2. Corporate relatedness: Provides opportunities for transferring corporate-level competencies across businesses of the firm.

Operational Relatedness: Sharing Activities

• Firms create operational relatedness by sharing either a primary activity or a support activity.
• Usually associated with the related constrained diversification strategy.
• Challenges of Activity Sharing:
  • Costly to implement and coordinate.
  • May create unequal benefits for divisions.
  • Can lead to fewer managerial risk-taking behaviors.

Corporate Relatedness: Transferring Core Competencies

• Corporate-level core competencies: Complex sets of resources and capabilities that link different businesses, primarily through managerial and technological knowledge, experience, and expertise.
• Firms using the related linked diversification strategy can create value by transferring core competencies in two ways:
  1. Eliminates the need for the receiving business to allocate resources to develop the competence, as the expense has already been incurred in another business.
  2. The unit receiving a transferred corporate-level competence often gains an immediate competitive advantage over rivals because intangible resources are difficult for competitors to understand and imitate.

Market Power Through Related Diversification

• Firms using a related diversification strategy (constrained or linked) can gain market power.
• Market power: A firm's ability to sell products above competitive price levels, reduce costs of primary and support activities below competitors' costs, or both.
• Multipoint competition: Rival firms often face pressure to diversify when competitors in their dominant industry segment acquire businesses to compete in different market segments, thus fostering increased market power.

Vertical Integration

• Definition: A company produces its own inputs (backward integration) or owns its own source of output distribution (forward integration).
• Benefits:
  • Save on operations.
  • Avoid sourcing and market costs.
  • Improve product quality.
  • Possibly protect technology from imitation.
  • Potentially exploit underlying capabilities in the marketplace.
• Limitations:
  • Internal transactions may be expensive and reduce profitability.
  • Bureaucratic costs may be present.
  • Requires substantial investments in specific technologies, reducing flexibility.
  • Changes in demand create capacity balance and coordination problems.

Simultaneous Operational and Corporate Relatedness

• The ability to simultaneously create economies of scale by sharing activities (operational relatedness) and transferring core competencies (corporate relatedness) is:
  • Difficult for competitors to understand and imitate.
  • Very expensive to undertake.
  • Often results in discounted assets by investors, as it can be difficult for investors to identify the created value.

Value Creation through Unrelated Diversification

• Firms using unrelated diversification do not seek operational or corporate relatedness.
• Financial economies: Cost savings realized through improved allocations of financial resources based on investments inside or outside the firm.
• An unrelated diversification strategy creates value through two types of financial economies:
  1. Efficient internal capital market allocation.
  2. Asset restructuring.

Efficient Internal Capital Market Allocation

• Ideal Market Economy: External capital markets are believed to efficiently allocate capital, as investors seek high expected future cash-flow values and debt holders improve investment values in high-growth/profitability businesses.
• Diversified Firms' Advantage:
  • Corporate headquarters distribute capital to businesses to create overall corporate value.
  • Managers at corporate headquarters have more detailed and accurate internal information regarding business performance and future prospects than external investors.
  • External investors have limited internal information and can only estimate individual business performances.
• Challenges:
  • Corporate office micromanaging business units.
  • Competitors can imitate financial economies more easily than economies of scope (operational and corporate relatedness).
• Context: These challenges are particularly relevant in developed economies, while the advantages of unrelated diversification may outweigh these problems in emerging economies.

Restructuring of Assets

• Financial economies can be created when firms learn to create value by:
  • Buying assets at a low cost.
  • Restructuring the assets.
  • Selling the assets at a price exceeding their cost in the external market.
• Difficulty with intangible assets: Buying, restructuring, and selling service-based assets for profit is challenging because technology firms and service-based companies have few tangible assets that can be restructured profitably.

Incentives Driving Value-Neutral Diversification

• The quality and quantity of a firm's resources might only permit value-neutral diversification, not value creation.
• Incentives to diversify come from external and internal environments.

External Incentives

• Antitrust Regulation:
  • 1960s-1970s: Stringent enforcement of antitrust laws against mergers creating market power (vertical or horizontal integration); most mergers were 'conglomerate'.
  • 1980s-early 1990s: Merger constraints relaxed, leading to more and larger horizontal mergers.
  • Early 2000s: Antitrust concerns re-emerged, and mergers received more scrutiny.
• Tax Laws:
  • 1960s-1970s: Dividends taxed more heavily than capital gains, encouraging shareholders to prefer firms use free cash flows to build companies in high-performance industries.
  • 1986 Tax Reform Act: Reduced individual ordinary income tax rate from 50 \% to 28 \% and treated capital gains as ordinary income, incentivizing shareholders to retain funds for diversification.
  • FASB Changes: Reduced incentives for acquisitions by eliminating the 'pooling of interests' accounting method and the write-off for in-process research and development.

Internal Incentives

• Low Performance: Research suggests low returns correlate with greater diversification levels. An overall curvilinear relationship may exist between diversification and performance. Difficulties can arise from negative synergy, leadership problems, and cultural fit issues.
• Uncertain Future Cash Flows and Reduced Risk of Failure:
  • Diversification can be a defensive strategy if a firm's product line matures or is threatened.
  • Diversifying into other product markets or businesses can reduce uncertainty about future cash flows.
  • A firm overexposed to failure risk due to interdependencies among related businesses or uncertain cash flows may diversify into different environments.
  • Neither diversifying for uncertain cash flows nor expanding into different environments is likely to create more value.
• The Pursuit of Synergy (potential vs. actual): While ideal, synergy can be elusive and lead to value-neutral outcomes if not realized.
• Tangible and Intangible Resources: The firm's existing resources and capabilities may only allow for diversification that does not significantly enhance value.

Managerial Motives to Diversify

• Managerial motives can exist independently of value-neutral or value-creating reasons.
• Value-Reducing Managerial Motives:
  • Reduced Managerial Employment Risk: Top-level executives may diversify to spread their own employment risk, provided profitability does not suffer excessively.
  • Higher Compensation: Diversification can increase a firm's size, which is highly correlated with executive compensation and social status. Managers may diversify a firm to a level that reduces its value (known as 'empire building') if profits drop significantly.
• Governance Mechanisms to Check Managerial Tendencies to Over-diversify:
  • The board of directors.
  • Monitoring by owners.
  • Executive compensation practices.
  • The threat of being taken over through an acquisition (capital market intervention) – although managers may use defensive tactics like 'poison pills'.
• Most large publicly held firms are profitable because managers are positive stewards of firm resources, and their strategic actions contribute to success.
• Top-level executives' diversification decisions may also be constrained by concerns for their reputation.