Strategic Managment

At the corporate level, the main concerns are:

• Which businesses should the firm be in (diversification)

• How should the firm manage its multiple businesses (portfolio management)

1. LEVELS OF DIVERSIFICATION

Corporate strategies can be classified based on the levels of diversification

 Low levels of diversification:

A firm has low levels of diversification when one of its businesses (referred to as the dominant business) generates 70% or more of its revenues. For firms that have low levels of diversification, there are two types of corporate strategies:

• Single-business strategy: corporate strategy used by firms whose dominant business generates more than 95 percent of revenues

• Dominant business strategy: corporate strategy used by firms whose dominant business generates between 70 and 95 percent of revenues

 Moderate levels of diversification:

A firm has moderate levels of diversification when the dominant business generates less than 70% of revenues. Firms with moderate levels of diversification are using a corporate strategy called related diversification. Businesses are related when they share product, technological and distribution linkages. There are two types of related diversification strategies:

• Related-constrained diversification: corporate strategy used by firms whose businesses (dominant business and other businesses) share product, technological, and distribution linkages.

• Related-linked diversification: corporate strategy used by firms whose businesses (dominant and others) share few product, technological and distribution linkages. Additionally, related linked firms start to also have some unrelated businesses (businesses with no linkages among them)

NOTE: Related diversification that involves businesses located along a firm’s value chain is referred to as vertical integration.

 High levels of diversification

A firm has high levels of diversification when it has several businesses, and none of them is dominant. Firms with high levels of diversification are using a strategy called unrelated diversification. Unrelated diversification is a corporate strategy used by firms whose businesses do not share linkages. Because these firms are highly diversified, they are referred to as conglomerates.

2. REASONS FOR DIVERSIFICATION

Firms diversify for three sets of motives: value-creating, value-neutral, and value-reducing motives.

 Value-creating motives

There are three main value-creating motives:

• Achieve economies of scope (related diversification): Economies of scope represent cost savings attributed to sharing activities with or transferring core competencies to a new related business without significant additional costs:

  • Sharing activities: Tangible resources such as plants and equipment or other physical assets often must be shared. Intangible resources, such as manufacturing know-how, also can be shared by related businesses

  • Transferring core competencies: Intangible resources and capabilities that can be transferred are corporate-level core competencies (managerial and technical knowledge, experiences, and expertise)

• Achieve market power (related diversification): Market power exists when a firm is able to sell its products at prices above the existing competitive level, or to decrease the costs of its primary activities below the competitive level, or both. Market power is gained primarily through vertical integration (V.I.). Vertical integration is a strategy whereby a firm performs the activities of other businesses along its value chain. For example, a firm can perform the activities of businesses that produce its inputs (backward V.I.). A firm can also perform the activities of businesses that dispose of (i.e. distribute) its outputs (forward V.I.). V.I. enables a firm to increase market power by avoiding or lowering market transaction costs, and/or by denying competitors access to inputs or distribution channels

• Realize financial economies (unrelated diversification): Financial economies are cost savings realized through either:

  • Efficient internal capital market allocation: Large diversified firms may be able to more efficiently allocate financial resources inside the firm to divisions (i.e. businesses) and thus create value for the overall organization. Improved efficiency is possible because the corporate office has more detailed and accurate information on actual division performance and future prospects

  • Restructuring of assets: Unrelated diversified firms can create value by buying underperforming companies (and their assets) in the external market and then restructuring them. Restructuring can lead to cost savings because acquired firms (now divisions of the acquiring firm) will be placed under effective management, strict budgetary controls accompanied by the reporting of cash inflows and outflows to the corporate office

 Value-neutral motives

There are several value-neutral motives, including:

• Avoid violations of antitrust regulations: In the 1960s and 1970s, government policies enforced antitrust laws as a way of preventing monopolies and therefore promoting free competition

• Take advantage of tax incentives: As a result of antitrust enforcement, government policies also provided tax incentives to firms that diversify into a mix of different businesses, primarily into unrelated businesses

• Overcome low performance: In response to low returns (or poor performance), firms often choose to seek greater levels of diversification.

• Reduce the uncertainty of future cash flows: Firms also may implement diversification strategies when their products reach maturity or are in the declining stage (in the product life cycle) or are threatened by external factors that the firm cannot overcome. Thus, firms may view diversification as a survival strategy

 Value-reducing motives

There are two main value-reducing motives (also called managerial motives):

• Diversify managerial employment risk: Diversification may enable managers to reduce employment risk (the risks related to the loss of their jobs or a reduction in compensation). The risk of losing job is low when diversification improves the overall performance of the firm

• Increase managerial compensation: Diversification allows corporate managers (CEOs) to earn higher compensation. This is based on the logic that large firms are more difficult to manage as they are more complex. Because CEOs manage complexity, they “deserve” a higher pay. Studies have shown that there is a positive correlation between diversification, firm size, and executive compensation.

3. PROBLEMS WITH DIVERSIFICATION

Often firms kept increasing their levels of diversification, which resulted in over-diversification (levels of diversification beyond which the benefits of diversification are offset by the costs of managing complexity). The costs are both financial and strategic.

 Financial costs

Financial costs include:

• Bureaucratic costs: Highly diversified firms have several divisions as well as several layers of management. This results in numerous mid-level managers and their staff. The costs of coordinating and controlling such a huge bureaucracy can substantially go up

• Production costs: In the case of vertical integration, production costs will go up (because of lack of competitive pressures). The costs of vertical integration may also increase because of differing scale efficiencies (e.g. a business produces more components than the assembly business can handle)

 Strategic costs

Strategic costs include:

• Loss of strategic focus: To add businesses, the attention of the corporate office is diverted away from the core business toward mergers and acquisitions negotiations (M&A)

• Less strategic flexibility: As corporate (and often scarce) resources are stretched over many different businesses, diversified firms end up investing less in innovative activities. Overtime, they will find themselves unable to quickly respond to environmental changes

• Shift from strategic to financial controls: Because of limited cognitive capability, corporate managers cannot understand the requirements of several businesses. To evaluate the performance of each business, they will shift from strategic to financial controls. Because financial controls are short-term oriented, corporate managers are likely to become ineffective in evaluating their firm’s ability to achieve and sustain competitive advantage.

4. CORPORATE RESTRUCTURING

As over-diversification led to poor performance, several diversified firms engaged in corporate restructuring. Corporate restructuring can be defined as a repositioning of assets (i.e. a change in the composition of a firm’s businesses) which is followed by a change in corporate strategies. Several highly firms restructured beginning in the early 1980s. There are four main corporate restructuring strategies:

 Mergers and acquisitions (M&A)

M&A are usually referred to as acquisitions, because the vast majority of them are acquisitions. M&A is a restructuring strategy whereby a firm buys more businesses which have core competencies needed to strengthen their core business. NOTE: Mergers and acquisitions are the topic of chapter 7.

 Downsizing

Numerous diversified firms downsized. Downsizing is a restructuring strategy whereby a firm engages in massive layoffs of employees (and managers). Downsizing is the least effective of all the restructuring strategies. Investors (that seeks dividends every quarter) react favorably to layoffs because of improvement in short-term performance. But massive layoffs do not correct the problem of high levels of diversification. As a result, firms that downsized, did so again and again, until they went into bankruptcy, or shifted to other restructuring strategies, or were bailed out by the government, or simply collapsed.

 Leveraged buyout (LBO)

Leveraged buyout is a restructuring strategy whereby managers (or employees, or even another firm) issue bonds to borrow money that is used to buy all stocks, thereby replacing stockholders by bondholders. If a firm loses money, stockholders won’t receive dividends. Bondholders however must get paid back (principal and interests) regardless of whether a firm makes profits or has losses. Replacing stockholders by bondholders will therefore put more pressures on corporate managers to improve performance. So LBO can be an effective restructuring strategy.

 Downscoping

Downscoping is a restructuring strategy whereby corporate managers get rid of businesses through either divestments (selling off of businesses), or spinoffs (one firm splits into two or more independent firms, each of them focusing on one or few businesses). The divestment of businesses located on the value chain of a firm is referred to as vertical disintegration (also known as vertical de-integration). Downscoping is the most effective of all the restructuring strategies because of a number of reasons. The firm can achieve strategic focus as corporate managers’ attention will be devoted to dealing with few businesses (more likely core business and maybe a few related businesses). The firm can also achieve strategic flexibility as resources from divestments can be used to invest in research and development (R&D) to enhance the innovative capability and quickly respond to changing environments. Additionally, corporate managers can shift back to strategic controls as they will better understand the strategic complexities of fewer (core and maybe few related) businesses.

5. PORTFOLIO MANAGEMENT

A key issue that diversified firms face is how to manage multiple businesses. Corporate managers need to determine which businesses to have, which ones to acquire, and which ones to get rid of.

 Strategic tools to manage multiple businesses

A number of frameworks have been developed to help corporate managers make sound decisions about managing several businesses. The framework that is most used is the BCG Matrix

 BCG Matrix

• A study conducted by a consulting firm called Boston Consulting Group (BCG) resulted in a framework called the BCG Matrix. Using two dimensions, one internal (relative market share of each business), and one external (growth rate of a business’ industry), four cells representing four types of businesses can be derived as follows:

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! ! !

High ! ! !

! STARS ! QUESTION !

! ! MARKS !

Industry ! ! !

Growth ! ! !

Rates ----------------------------------------------------------------------

! ! !

! CASH ! !

! COWS ! DOGS !

! ! !

Low ! ! !

! ! !

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High Low

Relative market shares

• Using the BCG Matrix:

  • Keep Stars

  • Keep Cash Cows

  • Divest Dogs

  • Divest weak Question Marks (Questions Marks that cannot be converted into Stars)

  • Use resources from divesting Dogs and weak Question Marks, along with resources from Cash Cows to strengthen weak Stars or promising Question Marks (Question Marks that can be converted into Stars)

• Weaknesses of the BCG Matrix:

  • Although it is mostly accurate, having a high market share does not automatically mean that a business is strong

  • Because of linkages among related businesses, divesting a business (e.g. Dogs) may weaken a business that should be kept (e.g. Stars)

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