MGMT 567 Managing the Multi-Business Firm Module 2a: To Diversify or Not to Diversify Copyright 2017 Montclair State University Business Tip Scenarios in Business: Eggs in One Basket Eggs in Different Baskets • Carnegie: • Amazon: Books –> Steel Everything –> AWS –> IoT • Rockefeller: • Berkshire Hathaway: Oil Textiles-> Insurance -> Others The Answer: It All Depends: • Knowledge, Experience, Competence • Resources, Strengths, SWOT • Return on Investment • …... MGMT 567 Managing the Multi-Business Firm Module 2b: How Can Diversification Add Value Reflection: Diversification and Created Value Think about a diversification that has created value, and why? Leveraging Strengths Front-end Back-end Exploiting Resources Enhancing Resources • Johnson & Johnson/P&G: consumer products • GE: electrical equipment • Amazon: AWS • Starbucks: food, CDs • Cisco: more networking equipment • Amazon: ebooks • Apple: iPhone, iPad • Disney: new movies & characters Mechanisms to Create Value: Synergy • Slack: Delta • Shared Knowledge: Honda • Similar Business Models: Virgin • Spreading Capital: Berkshire Hathaway • Stepping Stone: Apple MGMT 567 Managing the Multi-Business Firm Module 2c: How Can Diversification Destroy Value Reflection: Diversification and Destroyed Value Now, Think about a diversification that has destroyed value, and why? Time Warner & AOL Photo: Getty Images The Worst Acquisition of All Times • In 2000, AOL was the Internet darling and had a much higher market valuation than Time Warner • AOL bought “old media” firm Time Warner for $164 billion. • Within 18 months, the company had reported a $99 billion loss. • The two companies had to split again later in 2009. Diversification Drawback How Could Diversification Destroy Value? • 2002, near-$25bn deal to buy the Compaq, but ended with a $1.2bn writedown in the value of the trade name 10 years later. • In 2008, HP acquired IT services firm EDS for about 14b$, and later had to spin it off again in 2016. • In 2010, HP paid $1.2 billion for Palm to get into mobile devices. By the summer of 2011, HP decided to discontinue the entire thing • In 2011, HP paid $10.2 billion acquire Autonomy, an enterprise software company, and ended up taking a $8.8 billion write-off on that acquisition. How Could Diversification Destroy Value? (continued) ▪ Lack of Synergy ▪ Poor Incentives ▪ You cannot buy core competency! MGMT 567 Managing the Multi-Business Firm Module 2d: Diversify Through Acquisitions Entry mode: Greenfield • Existing resources move from existing to new business ▪ Brand ▪ Customer knowledge ▪ Technology overlap • Speed not essential Acquisition • Resources don’t move from existing to new business ▪ No brand equity ▪ New customers ▪ New technology • Speed essential Acquisition Integration Strategies Bury—completely absorb target Build—a new organization, best of breed Blend—loose coupling, leverage target Bolt-on—two companies, one owner Print this page Corporate Versus Business Unit Strategy The tools of industry analysis, low cost or differentiation strategies, and innovation help managers devise business unit strategy, or an approach for creating competitive advantage within a single industry, market, or line of business. Cisco, when viewed as a collection or portfolio of businesses, competes in a different, but related way than its individual business units. Cisco managers have a clear corporate strategy, or an approach for creating value and competitive advantages through participation in several different industries and markets. Corporate strategy entails competing in a core industry or business and also operating in adjacent businesses or markets. When those adjacent markets can be mapped along the value chain, then a firm vertically integrates. For example, when Apple made the decision in the early 1980s to develop its own computer operating system in-house, it vertically integrated backward by producing the inputs to its computers. Vertical integration represents such an important and unique form of diversification that Chapter 7 deals specifically with this topic. When a firm moves to an adjacent business or enters a new industry value chain, it engages in horizontal diversification, most commonly referred to simply as diversification. The adjacent market may mean selling the firm's existing products to new customer groups, bringing new products and services to existing customers, or selling new products and services to new customers. Managers diversify their firms through one of three methods: greenfield or organic entry, alliance, or acquisition. Alliances, like vertical integration, present the firm with a unique set of opportunities and challenges, so we'll discuss them separately in Chapter 8. This chapter describes both greenfield entry and acquisition as mechanisms of diversification. In this chapter, you'll learn how companies can create value by competing in several industries instead of just one, and how companies can diversify through greenfield entry or acquisition. Should a company choose to diversify through acquisition, you'll learn about the process of acquisition and understand how tightly a newly acquired business should be integrated into the company. Strategy and Your Career Video: How Can Corporate Strategy Help Me Think About My Career? Strategy and Your Career Video: How Can Corporate Strategy Help Me Develop My Career? Copyright © 2018, 2016 John Wiley & Sons, Inc. All rights reserved. Print this page Creating Value Through Diversification Early research by strategy scholars into corporate diversification identified an inverted curvilinear (an upsidedown, U-shaped) relationship between corporate diversification and profitability. Firms that compete in a few, related industries or markets outperform firms focused on a single industry. More is not always better, however, because firms that compete in many, unrelated industries perform worse than those in a few, related ones. A number of studies over the last three decades have come to the same general conclusion: Moderate diversification pays off but very high levels of diversification lead to lower levels of performance.11 Levels of Diversification Firms have several choices about how to diversify, and they have a range of options about how much to diversify. Strategy scholar Richard Rumelt created a continuum of diversification strategies based on the product market similarity of the firm's businesses. Firms range from related to unrelated diversifiers.12 A single business is one where more than 95 percent of the revenues come from a single line of business, most often measured in terms of the four-digit NAICS codes you learned about in Chapter 2. The dominant vertical business earns more than 70 percent of its revenue from its main line of business and the rest from businesses located along the value chain, either upstream (backward integration) or downstream (forward integration) from the core activity. A dominant business earns more than 70 percent of revenue from its main line of business and the remainder from other lines across different value chains. A related-constrained firm earns less than 70 percent of its revenue from its main line of business and its other lines of business share product, technological, and distribution linkages with the main business. Amazon Marketplace represents related-constrained diversification; Marketplace sells a similar product (used rather than new books) and uses the same technology (the Amazon website) and distribution network (UPS) as the parent company. Related-linked diversification occurs when the businesses are still related but fewer linkages exist between the new and existing business. Amazon Fresh, started in 2007, sells groceries (a different product group) over the web (same technology) for rapid home delivery (but not through UPS). Finally, an unrelated diversified firm competes in product categories and markets with few, if any, links between them. Unrelated firms are also called conglomerates and include firms such as General Electric and the 3M Company, also known as Minnesota Mining and Manufacturing. You might recognize 3M for its famous Post-It Notes and line of tapes, but the company sells a variety of products, from surgical materials for abdominal support to its dental restorative product ESPE Z100.13 For diversification to add value in the real world, managers must answer the following acid test questions: (1) Why will the existing businesses be more valuable because we've entered an adjacent business? and (2) Why will the new business activity be more valuable inside our corporation than operating alone? The simplest answers to these questions are the same as the answers to the fundamental strategy questions we raised in Chapter 1. Diversification adds value when it allows the combined businesses to deliver greater value and utility to new or existing customers than the firm could without being diversified. Diversification also adds value if the combined businesses reduce the firm's overall cost of producing goods or services. Value Creation: Exploit and Expand Resources and Capabilities Diversification adds value when expansion into an adjacent business either exploits the firm's valuable resources and capabilities or diversification enhances and grows the resource base. To provide more clarity to the notion of exploiting and expanding, you can divide a firm's resources and capabilities into two broad categories: a “front end” or customer-facing resources and capabilities and a technological and operational “back end.” Procter & Gamble's resources such as brands, product lines, distribution channels, and its capabilities in uncovering deep customer needs represent the customer-facing part of the business. Walmart's resources in terms of regional distribution centers and information systems and its capabilities in global supply chain management and cost reduction belong in the “back-end” group. Diversification allows companies to exploit their existing customer-facing resources by adding new operational resources and capabilities. General Electric's entry into the finance business in the early part of the twentieth century allowed it to solve a core problem for cities and towns: how to defray the huge upfront costs of electrification. Similarly, a business can exploit its existing technological and operational strengths to reach out to new customer groups. General Electric used its original skills in light bulb and electrical equipment manufacturing to enter a new, high-technology market at the end of the nineteenth century: X-ray machines. GE leveraged its knowledge and skill toward a new set of customers, doctors, hospitals, and patients. Diversification also creates value when it helps a company expand its existing set of resources and capabilities or diversification enables it to prepare for the future. Cisco makes a number of acquisitions designed to expand both its technology platforms and product lines. Cisco introduced its first Internet Protocol (IP) phone in 1998. In 1999, the company made three acquisitions, Sentient Networks, GeoTel Communications, and Amteva Technologies, that brought patents and products that Cisco needed to expand its business.14 Figure 6.1 illustrates the basic logic of value creation through exploiting or expanding resources and from either front- or back-end resources or capabilities. Value Through Value From Exploiting Resources Expanding Resources “Front-end”, customerfacing part of the business •Expand customer base •Better serve existing customers through more, better products •Gain new market knowledge •Add new brands •Identify new trends earlier “Back-end” operational parts of the business •Create economies of scope or increased scale •Broaden existing production capacity •Adopt new technology platforms •Improve quality, productivity, or other best practices •Access innovative process or product technologies •Enhance R&D capabilities or outputs Figure 6.1Adding Value Through Diversification The logic of exploiting or expanding resources and capabilities provides you with a deeper understanding of what it means for a firm to enter an adjacent market. Adjacent means “next to,” and we might think of adjacent markets as ones with products or services right next to each other. Starbucks sells food and mugs along with its premium coffee, but the company also sells CDs or other products. Food and mugs are naturally adjacent to coffee (people eat food with coffee and drink coffee in mugs), but music isn't. When we speak of an adjacent market, we mean a closely related market for creating value and utility for customers. Starbucks provides customers with a cup of coffee but also a relaxing place to hang out or meet up with others. Part of that environment entails music to set the mood. Starbucks captures the value of that music by offering CDs and other ambience products to customers. The notions of expanding and exploiting resources help you understand why companies can create sustainable competitive advantages. In the next section, you'll learn how companies actually create competitive advantage and business value through diversification. The Eight Ss Exploiting and/or expanding the resources and capabilities usually come through one of eight mechanisms. To help you remember these important elements, we've created a mnemonic device, the eight Ss: employing slack, creating synergy, leveraging shared knowledge, utilizing similar models for success, spreading human and financial capital to its best use, providing a stepping stone for the company to a completely new business sector, stopping or slowing competitors, and staying even with of technological change. As you read through each S, try to think about how each would help a company exploit or expand its resources and capabilities. Each of the Ss can work through the customer-facing front end of the business or the operational and technological back end. Employing Slack Slack means unused resource capacity. Delta Airlines generated almost $37.7 billion in revenue in 2012 through its combined operation, almost $1 billion carrying cargo and freight.15 Why would Delta, whose primary customers are people, be involved in the back-end freight business? The top half of the aircraft carries people, the bottom half carries the luggage. There's often extra room in the bottom of the plane that Delta can fill with freight cargo at almost no cost! Transporting cargo adds value because it captures slack in the form of an economy of scope. An economy of scope arises when the average cost of producing two different products is less when delivered together than separately. Management skill often represents another unused resource. Firms can only grow as fast as they have knowledgeable and skilled managers to guide that growth.16 This has an important corollary: As managers learn their jobs and develop skill, they are able to effectively handle an increased number of activities. Marriott, the upscale hotel operator, competed for many years to service business travelers in hotels noted for excellent service. In the late 1980s, the company started its economy chain of Fairfield Inns and the extended-stay Marriott Suites hotel. Marriott became the first major hotelier to offer a portfolio of brands.17 In the mid-1990s, Marriott moved into the adjacent but upscale hotel segment with its purchase of the fabled Ritz-Carlton brand.18 Employing slack usually creates value through exploitation although sometimes during an acquisition a company may acquire redundant resources that expand slack.19 Creating Synergy Synergy occurs when different elements of a system interact in a way that creates more value together than the elements create separately. Simply put, the whole exceeds the sum of its parts. Disney competes in two adjacent entertainment markets, films and theme parks. The two businesses create more brand value for Disney together than either would separately. For example, customers' emotional connection with Disney deepens when they interact with the same characters at a distance in movies and then up close through attractions at the parks. Procter & Gamble gains operational leverage with retailers when it negotiates for shelf space because the company offers retailers a portfolio of important products and can bundle different products to maximize potential revenue for retailers. P&G saves on distribution and logistics costs as trucks carry multiple products to each retail location. Synergy clearly exploits the resources and capabilities to offer customers better products and services. Synergy also increases the number and ways a company interacts with its customers, and that can expand its capabilities to meet customer needs in the future. Shared Knowledge Think of a diversified company as a tree: the leaves, twigs, and branches represent different product markets and industries, but the competitive advantage comes from the common roots, processes, or knowledge. These roots are often called core competencies, “the collective learning in the organization, especially how to coordinate diverse production skills and integrate multiple streams of technologies.”20 Core competencies represent a set of resources or capabilities at the center of the diversified corporation that are distributed to individual businesses to adapt for their particular markets. Honda parlays operational and technological knowledge and ability in engine design and performance into several diverse downstream markets, including automobiles, lawnmowers, and consumer generators. ESPN's ability to extend its brand and reputation for serious and engaging sports coverage creates competitive advantage across its 70 different brand platforms.21 These include the flagship broadcast properties and websites, as well as the magazine, apparel, and restaurant businesses. Honda's core competencies at highquality engine design attract a broad set of customers to its products, while ESPN's core competencies (or shared knowledge) allow the company to service sports fans over a variety of technological platforms. Shared knowledge helps you understand why some very unrelated product markets can represent valuable adjacent markets. Similar Business Models A business model is a method for enabling value to be created and exchanged between companies and their customers. General Motors' business model involves transforming raw materials such as steel, rubber, and plastic into automobiles, all done at very large scale. eBay's business model is to provide an electronic venue, or market, where buyers and sellers can come together. Strategy scholars note that some business models have common elements or keys to success. They describe these commonalities as a dominant logic or “the way managers conceptualize the business and make critical resource allocation decisions—be it in technologies, product development, distribution, advertising, or human resource management.”22 A dominant logic implies that some businesses may look very different at the level of products or services but may share a set of management principles and skills, such as managing a workforce filled with skilled labor, or be subject to the same economic processes such as stage in the life cycle, similar barriers to entry, or economies of scale. Strategy in Practice Creating Value at Newell Rubbermaid Newell Rubbermaid (Symbol NWL, 2015 Revenues: $5.91 billion) traces its origin to 1903, when Edgar A. Newell purchased the assets of curtain rod manufacturer W. F. Linton. Newell's original focus lay in improving curtain rods through technology, production improvements, and cost reduction. In 1912, the company began selling its products through mass merchandizer Woolworth, and business took off. As the company grew over the years, it broadened the product line to include other low-technology window treatment products such as extension rods, drapery pin hooks, and curtain holdbacks.23 In 1965, new CEO Dan Ferguson decided on a new strategy; rather than focus solely on window treatments, the company would use mergers and acquisitions to become a major player in housewares and hardware goods, specifically low-technology products marketed through mass retailers. Increasing the product line would create better leverage with the company's target customers: chains such as Woolworth and K-Mart. With the purchase of the EZ Paintr Corporation in 1974, the company made its first substantial jump outside its traditional markets. Ferguson would make 70 acquisitions during his 30-year tenure as CEO, including glass maker Anchor Hocking, cookware manufacturer WearEver, and later Calphalon, and Levelor window blinds. Newell's acquisition formula exhibits a dominant logic. Each of the target companies mass produce relatively lowtechnology consumer goods in different grades (good, better, best), and each company distributes its products through mass retailers. After taking control of its targets, the company follows a rigorous process of “Newellizing” its new acquisition.24 Newell uses its deep and extensive knowledge of its customer, mass retailers, to help its acquisitions reconfigure product lines and categories to satisfy the needs of its customers. Newell eliminates duplicate product lines and makes sure that the company's offerings fit into the “good, better, best” quality logic that lies at the core of its success. Newell creates back-end synergies by eliminating duplicate functions such as separate sales staffs or headquarters expenses, as well as sharing production technologies and processes. Newell uses its dominant logic knowledge to help the acquired company reduce costs, improve manufacturing to find efficiencies, improve financial controls and metrics, and improve cash flow. The Japanese company Sumitomo Heavy Industries competes in a number of different industries. The company has business divisions in power generation, plastics machinery (like injection molding tools and dyes), industrial equipment, precision instruments (such as extreme cryogenic refrigeration), defense systems, ship building, and others. These don't seem adjacent at all, but a closer look reveals that each business shares two back-end commonalities: advanced engineering and huge fixed costs. Success in each business area depends on the ability to attract and retain scientific talent that will drive innovation and managing a set of very sophisticated physical assets that require substantial capital investments. The Strategy in Practice feature details a company with a customer facing dominant logic. Spreading Capital Some companies create value through diversification by acting as an internal capital market.25 They create value across business units by moving funds, talent, or knowledge from unit to unit. Rather than leaving resources within a business unit for its own growth, these strategic investments work to increase the corporate value by investing in business units with greater potential growth in the future. Spreading capital depends on detailed performance information for each unit, as well as an intuitive sense about the value of future investments. As a consequence, these managers can fund business growth at a lower cost of capital than if units relied on external sources such as banks or capital markets.26 Companies creating value through an internal capital market look like the definition of conglomerates—business units with little in common in the products or processes. Executives keep these businesses as separate units in order to accurately assess and reward performance. Since there is no sharing of resources, managers have no other divisions to blame if their units perform poorly. Keeping business units separate also allows corporate executives to sell units to willing buyers. Spreading capital exploits the management team's unique abilities to invest for value, and each new investment enhances the team's collective learning. Read the Strategy in Practice feature to learn about the challenges of the spreading capital strategy at ITT. Provide a Stepping Stone to a New Industry While the other Ss all exploit a company's current resources and capabilities, the stepping stone mechanism explicitly works to enhance capabilities. Executives may survey the landscape of the industry and its future trends and decide that their competitive position will not be sustainable and their money would be best invested in some other business segment. Successfully shifting the firm's position through diversification usually entails migration, creating a path so the company can avoid “long leaps” from its core into a segment where its resources and capabilities create little value. The path involves a set of “short leaps” executed over time that allows the company to acquire new resources and capabilities. Adjacent markets have two characteristics: (1) they allow the firm to exploit some of its resources and capabilities to create value; and (2) they allow the firm to acquire related resources and capabilities to prepare for the next step.30 Consider the case of Safeguard Scientific in the 1990s.31 In 1991, the company's major line of business was computer peripherals, an industry that includes keyboards, printers, and storage devices. By 2003, the company had shifted its major line of business to the optical instruments business, products such as advanced lenses, scopes, and optical scanning equipment. Safeguard didn't just jump from keyboards to scientific equipment; it migrated through adjacent industries to acquire skills and capabilities. In 1993, the company moved into producing telephone equipment, and then, in 1995, into electrical instruments. The company exited computer peripherals in 1996, the same year it entered optical instruments. It exited the telephone business in 1999. Instead of one “long leap” from computer equipment to optical devices, Safeguard took a number of “short hops” through industries where it could leverage existing capabilities and build new ones. The stepping-stone path allowed the company to acquire a new set of back-end operational skills and technology. The company also had to acquire a new set of customer-facing elements, as well. Strategy in Practice The Challenges of a Conglomerate: ITT Industries The company that would become ITT Industries began in 1920 when two brothers, Sosthenes and Hernand Behn, started to build the world's system of interconnected telephone lines. They succeeded, and over the next four decades, their company became a provider of international telephone services and the switching equipment that powered large networks.27 Harold Geneen became the CEO of ITT in 1959, and over the next seventeen years he would transform the company from $750 million in annual sales to $17 billion in annual sales. How did he do it? Through diversification! Geneen's ITT acquired more than 350 companies—at one point closing one deal per week—and the company expanded operations into 2,000 business units. ITT epitomized the term conglomerate, or a group of companies cobbled together simply to grow revenues and earnings. ITT owned businesses as diverse as the Sheraton Hotel chain, Avis Rent-A-Car, the Hartford Insurance Company, and the maker of Wonder Bread. Geneen referred to his company as a “unified-management, multi-product company.”28 The problem for ITT was, however, managing 2,000 different businesses, most of them quite unrelated. By the end of Geneen's tenure, the board and his successor realized that the company's portfolio of businesses destroyed value for shareholders. ITT split itself into three companies, a group of industrial companies driven by synergies and similar processes, the insurance and financial services businesses, and a group that contained all the rest of the businesses. With highly efficient markets for financial capital, equipment, and physical capital, and labor markets that move human capital, the job of allocating scarce and valuable resources is better accomplished through the market. The conglomerate form fell out of favor, but the logic of spreading capital still makes sense in emerging markets, where sophisticated and transparent markets for financial and human capital do not yet exist.29 Stopping Competitors While exploiting and expanding the resources base is the general rule of diversification, sometimes it makes sense for a company to enter a market, either through greenfield or acquisition, to keep a competitor from occupying that market space. In markets with fierce competition and evenly matched competitors, strategic managers might choose to diversify to forestall a competitor from entering, rather than to clearly exploit or expand a current resource or capability. The tech sector often sees a major company acquiring a new, unproven startup to keep the technology and/or market out of the hands of a potential competitor. Google's 2013 purchase of the Israeli startup Waze for almost $1 billion seemed overpriced, given that Google Maps was already used by more than half of smartphone users. Google wanted to keep Waze out of the hands of Apple, however, as Tim Cook had made improving Apple's mapping app a high priority. With Waze out of the market, Apple had to invest in internal development that took much longer to complete. Google did add some features developed by its target, but the real value for Google came from slowing, if not stopping, Apple's progress.32 The primary goal of stopping competitors, however, remains keeping valuable assets out of the hands of competitors and forcing them to keep even with of your firm. Staying Ahead of Technology If a company competes in an industry where technology changes rapidly, such as the life sciences or information technology, then diversification, primarily through acquisition, can shorten lead times and reduce the overall costs of technology development. Cisco's acquisition activity is driven as much by its desire to buy emerging technology as it is in buying a revenue stream; acquisitions allow companies to buy fully-developed, and sometimes market tested, technologies rather than developing them in-house. Many firms, particularly in the technology sector, operate corporate venture capital (CVC) businesses to keep even with emerging technologies. These units operate like independent VC firms in that they manage an active portfolio of startup companies. Like regular VCs, CVC units are judged on returns, and managers win when portfolio companies go public (IPO) or get acquired. Unlike independent VCs, however, corporate venture capital units win when the technology available in a startup can be transferred to the corporate parent.33 CVC firms use their position on a startup's board of directors to learn about new technologies, both within the startup and among the startup's competitors or industry. In 2015, CVC activity surpassed $28 billion, and established companies such as Caterpillar and Airbus have joined the likes of Intel and Cisco in CVC activity.34 Destroying Value Through Diversification The eight Ss show how and where managers can create value for shareholders of a diversified firm; however, one relatively robust finding from scholars in corporate finance is that diversified firms often trade at a discount versus undiversified rivals and that increasing diversification (entering additional new lines of business) tends to destroy shareholder value.35 If you think of the acid test for value we presented earlier, diversification destroys value when the new line of business fails to exploit or expand the company's resources and capabilities in meaningful ways. Value usually gets destroyed in one of five ways: excessive pride; sunk cost fallacy; imitative diversification; poor governance and incentives; or the lack of resource commonality between the lines of business. Hubris Managers may diversify based on their own beliefs about the potential of their company's ability to create value in the adjacent market. Hubris is an ancient Greek word for excessive pride, arrogance, or overconfidence.36 Managers act with hubris when they diversify or make acquisitions based on their own experience or their “gut feelings” rather than on solid data and research. Researchers have argued for, and demonstrated, the hubris hypothesis as an explanation for the poor performance of so many acquisitions.37 Sunk Cost Fallacy Closely related to hubris as a reason why diversification fails is the sunk cost fallacy, whereby managers believe that their investment in a failed acquisition just needs more incremental investment in order to succeed. Executives are often reluctant to abandon a project in which they have already invested so much time and capital; they often move forward under the assumption that “things will turn around with a little more investment.” The sunk cost fallacy leads managers on a path of escalating commitment to invest resources in failed, or failing, diversification efforts. Imitation Managers sometimes feel pressure to diversify their corporation when a competitor diversifies first. The competitor has done due diligence and selected an attractive target for acquisition, or made a greenfield entry after careful research and planning. Caught off-guard, a firm might quickly look for a similar acquisition target or hurry to create a similar line of business. In their rush to respond, managers fail to consider how attractive the target really is, or if they have the resources and capabilities that make the new market a value adding adjacency. In 2001, shipping leader UPS bought Mailboxes, Etc. for $191 million to give the company 4,300 new drop-off locations. FedEx responded by paying $2.4 billion for 1,200 Kinko's copy centers. FedEx bought fewer stores for more money and had to figure out how to incorporate Kinko's huge copy business into its operations.38 While both companies sought to expand into an attractive adjacent market, by being the first mover UPS found the more attractive target. FedEx struggled because it had to integrate a set of resources that aligned poorly with the company's core. Kinko's resources and capabilities were not oriented to truly exploit FedEx's. Poor Governance and Incentives Managers receive compensation based on how their companies perform. The threat of failure and the thrill of profit-based rewards create a set of high-powered incentives for managers to run their businesses effectively.39 When they become part of a diversified corporation, however, those managers sometimes move to salary-based compensation that divorces their pay from their performance. Further, within a diversified firm, managers' decisions must account for internal politics, resource allocation constraints, or mandatory transfers with other divisions. The division becomes less valuable inside the corporation because managers have weak incentives to focus on exploiting and expanding resources and capabilities and stronger incentives to focus their energy in other areas. Poor Management How do managers, given their limited time, energy, and mental resources, guide and direct the diversified firm? Sometimes they use models that relegate their different investments to simplified categories and then provide a management rule for each category. The Boston Consulting Group's growth share matrix represents one such tool. Figure 6.2 illustrates the growth share matrix. Figure 6.2The BCG Matrix In the growth share matrix, units contribute to corporate value creation in one of two ways, they either serve as engines of revenue growth or they generate cash flows for the firm to reinvest or distribute to shareholders. Executives classified business units as high or low on each dimension and applied a set of rules for managing each different quadrant. Cash cows have high share but low growth and can generate large cash flows that can be used to fund growth businesses. Companies typically like to minimize investments in cash cows because the goal is to milk the cow. Stars combine high share with high growth and smart managers should invest heavily in these units to maintain or improve their position over time. These businesses typically represent the future of the company. Question marks, as their name implies, present a conundrum for management because they require significant investment and effective strategic management if they are to become stars. But if not managed correctly, the significant investments may not move them into the star quadrant and instead they may move into the dog quadrant when growth slows. Dogs have low share and low growth and add little profitability to a company's overall portfolio businesses. The general rule is to divest the dogs. As you can easily see, the growth share matrix says almost nothing about whether cash cows, dogs, question marks, or stars help the corporation exploit or expand a company's resources and capabilities. Companies that slavishly follow tools such as this will often miss important sources of value available in their portfolio. For example, a dog business may have low growth because it competes in an emerging industry using cutting edge technology. Divesting the dog may prevent the company from understanding a new technology platform at its inception. Lack of Resources Think back to our feature on ITT. A single management system that operates 2,000 different business units relies on very high level financial measures, such as return on invested capital, to make decisions about which businesses will grow and which will stagnate. What ITT lacked, and why it eventually broke itself apart, was the ability to understand and respond to the unique strategic needs of each market, customer group, and line of business. Most of ITT's business units would offer very negative answers to the questions of value at the beginning of the chapter. Each business gained little of value by membership in the corporation and each added little value in return. In this section, you've learned why and when diversification adds value. In the next section, we'll introduce a set of tools that strategic managers can use to evaluate the different business units in their portfolio. Copyright © 2018, 2016 John Wiley & Sons, Inc. All rights reserved. Print this page Methods of Diversification Once firms decide to diversify their operations, the next question they must answer concerns how to diversify: Should they use greenfield entry by opening their own operations, or should they acquire a company already in the target market or industry? Moreover, if they do decide to enter via acquisition, how do they select a target, get the deal done, and successfully integrate the new company into the portfolio? Table 6.1 displays some criteria that managers should consider when choosing their mode of entry. The table aids analysis by dividing resources into front- and back-end categories, and also includes the important criteria of scalebased advantages and timing issues for market entry. Greenfield entry makes sense, first and foremost, when companies have the front-end and back-end resources and capabilities they can immediately exploit to create value. For example, GE's entry into medical products in the early 1900s drew on its core technical expertise in designing and manufacturing electrical equipment. GE opened its own finance unit to effectively exploit its deep knowledge of the buying process for electrification systems and customer characteristics. Competitive Dimension Greenfield Entry Acquisition Brands Brands well-known in the new markets and little advertising needed Brands not well-known in the new market and heavy advertising will be required Customers Customers in new market similar to existing customers Customers in new market very different from existing ones Channels Many channels available that the firm can easily access Few channels available or access to channels difficult and expensive Human Capital Standardized knowledge and skills that can be easily gained Unique or tacit knowledge and skill Technology New technology integrates easily with existing processes New technology does not integrate easily with existing processes Scale Economies of scale add few, if any, advantages Significant economies of scale or learning effects that confer strategic advantage Front End Resources Back-End Resources Competitive Dimension Speed Greenfield Entry Acquisition Slow, deliberate entry enables growth of solid market position Rapid entry needed to capture opportunity Table6.1Greenfield Entry versus Acquisition Greenfield also makes sense when companies can afford to enter new arenas slowly and at small to moderate investment. Conversely, acquisition, the outright purchase of another company, becomes the preferred mode of entry when the firm needs to quickly expand its own resources and capabilities to effectively compete. Acquisitions make sense when delay proves costly. In many technology businesses with sophisticated technologies and long lead times for development, companies that enter through greenfield may be too far behind to ever catch up. Acquisition also makes sense if the industry favors competitors with large scale or is characterized by a steep learning or experience curve. You may be tempted to think that greenfield entry represents value through exploitation and acquisitions through expansion. That oversimplifies the analysis; acquisition may prove the preferred choice when any one of the target markets meets any one of the criteria outlined above. GE's 2012 purchase of Italian aerospace company Avio may look like just another addition to a large conglomerate, but this acquisition both exploited and enabled GE's position in the aircraft industry.40 GE's 2015 divestiture of most of its GE Capital unit was designed to retain only those financing operations that would directly benefit customers of GE's other divisions.41 Once managers decide to acquire another business, firms that have developed an acquisition capability initiate a well-defined process to examine, purchase, and then bring the new entity into the corporate fold. In this section we'll explain the four essential steps in that process: identifying potential targets, selecting which of these to purchase, doing the deal, and integrating the acquisition after the deal closes. Copyright © 2018, 2016 John Wiley & Sons, Inc. All rights reserved. Print this page The Acquisition and Integration Process Acquisitions represent an opportunity to create, or destroy, value for the firm. In 2015, for example, the American economy witnessed over 12,000 mergers or acquisitions, with almost 300 valued in excess of $1 billion.42 In spite of its prevalence in the US economy, most mergers or acquisitions fail to create value for shareholders. Estimates vary, but between 70 percent and 90 percent of mergers don't work out.43 Making the Acquisition Before searching for a firm to purchase, managers must understand the real, value-creating need behind the move. Good reasons to diversify center on both the acquiring and target firm's resources and capabilities. Value creating acquisitions will either exploit the value of a firm's current stock of resources or the acquisition will enhance the firm's resources and capabilities. Poor reasons for acquisitions include simply adding top line revenue growth or doing a deal just because a competitor recently did one. These reasons make clear how the acquisition makes the current corporation more valuable; however, managers must also answer other questions: Why and how will the target firm be more valuable because we own it? The answer to these questions comes from the eight Ss above. The best acquisitions create value for both the acquiring and acquired firm. After making a list of potential targets that pass the first screen, the next phase requires the firm to perform a due diligence audit on each potential target. Due diligence means to closely examine the target firm to understand its core processes, strengths, and weaknesses. Newell Corporation's 1999 purchase of Rubbermaid illustrates the problems that inattention to due diligence can create. Newell essentially bought Rubbermaid's revenues and profits; it had little to offer Rubbermaid in terms of resources and capabilities and the same held true for Rubbermaid.44 Newell rushed its financial due diligence and failed to see that, within legal bounds, Rubbermaid created a picture of a business in better condition than the actual corporation. Rubbermaid proved to be what one analyst termed, “a perfumed pig” and Newell overpaid as a result. Newell Chairman Daniel Ferguson stated, “We should have paid $31 per share but we paid $38.”45 Failure to follow these steps required Newell to write off $500 million of merger-related goodwill in 2002. Once a potential candidate passes the value screen and survives the due diligence process, managers at the acquiring firm must decide how much they are willing to pay for the target. A number of tools exist to help with the valuation; firms often hire investment bankers or advisors to help them.46 Acquirers must pay a premium to acquire a target; the premium represents a bet by the acquirer on its ability to create value through the acquisition. In the United States, the average premium that the acquiring firm pays for a target firm is roughly 30 percent. For example, Newell originally offered just over $34/share for Rubbermaid, which was then trading at about $26/share, but eventually paid $38 per share.47 The process of acquisition plays an important strategic role for firms, and it represents a source of ethical challenges for managers and executives. Our Ethics and Strategy feature invites you to think through one such dilemma. Integrating the Target The acquisition premium creates two challenges for the acquiring firm. First, the larger the premium, the more value they must actually create to justify the acquisition. Second, given the time value of money, the larger the premium, the quicker the acquirer must create that value. For example, a hefty premium, coupled with large debt to close the deal, strongly encourages (forces) managers of the acquiring firm to create real value in order to pay off the debt.50 Strategy and management researchers suggest that acquisition represents a risky strategy for value creation with failure rates as high as 90 percent in some industries.51 Acquisitions may fail to create value because of poor strategic fit, incomplete due diligence, or a high acquisition price, but also because the acquiring firm fails to properly integrate the firm into its portfolio. Proper integration, like everything else, depends on the firm's overall strategy and, more specifically on which of the eight Ss the corporation uses to create value through diversification. Integration means the degree to which the two companies share facilities, operating procedures, compensation systems, organizational structures, and even cultural norms. Sometimes, an acquiring firm will need to tightly integrate the acquired firm into its own organization, but other strategies require the two firms to operate relatively (or completely) separate. Figure 6.3 illustrates the link between the degree of integration and the source of value creation. Figure 6.3Determining the Proper Degree of Integration Managers in the firm tasked with integrating the new acquisition must decide which activities or operations to integrate and how completely or tightly coupled the target and company will be linked together. The tighter the degree of integration, the more the combined entity looks and acts like a single firm. Conversely, loose integration allows each company autonomy in its business operations. Firms may follow one of four general integration strategies: They can bury the target through complete integration, build a brand new entity with the combined entities through tight integration, blend in the target to the corporation using best practices from each, or bolt on the target to the existing company only where it makes sense. Table 6.2 summarizes each approach; we will describe each in more detail. Element/Strategy Bury Build Blend Bolt On Integration Complete Tight Moderate—loose None Brand and Identity Acquirer maintains, Target loses New, combined Target maintains front end Target retains Element/Strategy Bury Build Blend Bolt On Back-End Operations Acquirer imposed Best of breed Acquirer dominates Separate Customer Facing Operations Acquirer imposed Combined, Best of Breed Separate Separate Table6.2General Integration Strategies Ethics and Strategy Transparency During the Acquisition Process When a company makes an acquisition, how much should it disclose about its true intentions to the employees of the acquired firm? Cisco Systems CEO John Chambers talks about the importance of treating employees of the acquired firm well, as he believes “you're only acquiring employees.”48 Cisco has acquired almost 200 companies, and its core values reflect Chambers's concern for employees: integrity, respect for individuals, and open communication. These core values have led to many successful acquisitions by Cisco as target companies have been successfully integrated into the Cisco family. Open communication and respect for individuals seem to be straightforward values, but each of these raise ethical issues for strategic managers during the integration process. Strategists usually have several objectives in mind when making an acquisition. The firm might buy the ability to offer certain products or services, it may purchase another firm for access to production processes, plants, or favorable locations, managers may target intellectual property such as patents and trademarks in an acquisition, or strategists may seek to lock up unique and valuable human capital. The point is that when an acquiring firm considers a target, it might have multiple objectives in mind. The firm might fully integrate some divisions or elements, allow others to run as a separate business, and close down or sell off others. The ethical issue involves the trade-off between the acquirer's desires to move efficiently and effectively versus stakeholders' (primarily employees but also customers and suppliers) needs for information in making their own plan. Here's an example. Consider two regional nursing home operators, Blue Heron and White Swan.49 Each company uses acquisitions to grow and expand into new regions. In this case, Blue Heron and White Swan each purchased a family-owned, local set of nursing homes to gain entry into the Southwestern region of the United States. Both acquirers follow a prescribed list of 90-day objectives integration plan to bury the acquired firm. The objectives include implementing the corporate technology platform, migrating purchases to the acquirer's preferred vendors, assessing the need for capital investments in the newly acquired units, and training employees on Blue Heron or White Swan procedures and protocols. At the end of the 90 days, both acquirers always replace the unit's existing general manager to bring in their own staff who are familiar with the existing culture, processes, and strategies. The ethical challenge for Blue Heron and White Swan is that during the 90-day transition period, the acquired unit's manager-in-place can play a key role in the efficiency and effectiveness of the transition. How much information should leaders of the acquiring firm share with the unit managers about their ultimate plans? If they tell the managers of their impending termination, they run the risk of losing a valuable player during the transition process. However, withholding that information raises fairness concerns for the unit managers; they could have used that 90-day period to find and secure new employment. How would you resolve this dilemma? Blue Heron operates as a business first and foremost. Its belief is that the most important goal is to ensure efficiency and effectiveness during the transition. Managers are interchangeable, and Blue Heron does not disclose its true intentions to the unit managers until they receive termination notices at the end of the 90 days. White Swan, also deeply committed to creating value for shareholders, opts for a different, open approach. Its managers sit down with the unit managers at the beginning of the process and disclose their ultimate plans. White Swan offers those managers increased pay and a bonus for the transition period, outplacement help in finding a new position, and the promise of a very positive reference if the job is well done. White Swan refuses to trade off its obligations to owners and employees. The owners get a smooth and effective transition, and employees are treated with dignity, fairness, and respect. Bury Another term for bury is takeover, where the acquiring firm breaks up the target firm and weaves its individual elements (e.g., product lines, employees, manufacturing facilities) into the fabric of the acquiring firm. The target's brand, culture, and identity all disappear; both the back-end operations and customer-facing aspects of the acquirer remain unchanged, although supplemented by the addition of the target's assets. Apple's acquisitions of more than 40 start-up firms have followed this pattern, including NeXT, eMagic, and Siri (yes, it used the Siri name for the personal digital assistant on the iPhone). The target firm ceases to exist as Apple assimilates and disperses the valuable elements of the firm throughout its existing organization.52 Build The traditional term merger represents what companies do when they build one new firm from the components of the two. The degree of integration is not as high as in the bury strategy, but a new identity, culture, and corporate brand emerges when the deal closes. Back-end and customer-facing aspects of the business use the best in class processes of either company. In 1998, auto giants Daimler-Benz and Chrysler merged, resulting in DaimlerChrysler AG, with a stated goal of increasing global customer share by sharing best operating practices between the two businesses. This bold strategy required the companies to truly build a new organization, on both the customer front-end and operational back-end. Unfortunately, the companies split in 2007 after it became apparent that the “merger of equals” was really an acquisition of Chrysler by Daimler. Building a new company may be the hardest integration strategy of all. Blend A blended acquisition results in a moderate degree of integration. The target firm retains its own identity, brand, and much of its culture and operating autonomy. Acquirers may transfer many back-end practices to the acquired firm, as Newell does when it “Newellizes” an acquisition; the company may choose to share fewer processes and practices, such as GE's management of many of its acquisitions. Customer-facing aspects of the business remain largely separate to capitalize on the strength of each company in its market. When companies add value through synergy, shared knowledge, or similar processes, a blending strategy helps create new value while preserving the strengths of each company. Bolt On The metaphor of bolting on an acquisition implies two separate entities joined at a single point through a very strong link. In a bolt-on acquisition, the two entities remain deliberately separate in order to monitor the performance of each unit. The link between the two businesses usually lies in the transfer of cash between divisions, either in the form of capital investment from the acquirer to the acquired or the payment of a dividend in the reverse direction. ITT exemplifies the bolt-on model; each business unit was connected with the corporate center only through financial reporting. Because the goal of each unit was to contribute cash and operating profit rather than knowledge or strategically valuable assets, the bolt-on model was the only appropriate integration choice for ITT to create any value. The different business units could make no excuses that achieving larger corporate goals had influenced their individual earnings; the bolt-on model preserved operating transparency among the many different businesses. Regardless of the integration template managers in the acquiring firm choose, attention to a number integration processes work to create a smooth and successful acquisition. These processes begin with the creation of a dedicated integration team as soon as the deal is announced. The most successful integration teams are jointly led by high-profile executives from both the acquiring and acquired firm; the credibility and authority of these teams helps break down barriers to change and integration in both companies. The team should be composed of subject area experts within each business function, such as human resources, marketing, operations, and finance/accounting.53 Each element of the new business that will be integrated needs its own specialist on the integration team to lead and monitor the effort. Finally, members of the best integrations work full time in these roles. Full-time status allows these individuals to supplement their functional knowledge with expertise specific to the acquisition process. This team makes several key decisions that create a successful acquisition. The first decision involves which company culture will dominate the new entity. Culture, norms, and values that define “how things are done around here” are the most important elements in the process. The acquiring firm usually wants its culture to dominate the new company, but people in the acquired firm often want their culture to persist. The resulting cultural clash can sabotage the entire integration process. A more difficult option entails building a new culture that combines the best elements of each company's culture.54 Speed matters in the integration process. When people see that the new company creates value for its stakeholders, including themselves, they become willing to change their own behaviors and truly join the new organization. The quicker the integration team can create clear successes, the more quickly members of the acquired firm dedicate their energy to making the venture succeed. This principle underlies Cisco's practice of having the acquired company's products for sale by Cisco employees on day one of the new relationship. The team decides which tactical elements and operational functions of the two firms will be integrated and implements whichever strategic integration template the firm chooses. Several other processes ensure that the merger, once finalized, creates value as soon as possible. These include determining a clear day-one set of priorities and tasks to realize immediate value from the deal, establishing a clear set of measures or key performance indicators (KPIs) to monitor progress, a clear path for implementing new systems in operations, marketing, or information systems, and a commitment to clearly communicate, in fact over communicate, the rationale and goals for the acquisition and the measurable progress toward those goals. We close this chapter by looking at General Electric to see how the company has mastered the acquisition integration process. Strategy in Practice How GE Integrates Acquisitions55 General Electric's financial services unit, GE Capital, made over 100 acquisitions in a five-year period. With acquisition such an essential element of the unit's strategy and the sheer number of acquisitions to integrate into an already-diverse portfolio, GE managers used this period of intense activity to perfect a system for integrating new acquisitions. The process worked very well, resulting in a systematic framework that the unit—and other companies—could use to improve the odds of success in an inherently difficult enterprise. GE's system built on four powerful lessons they learned through experience: 1.Acquisition is a process, not an event. Acquisition begins long before the deal closes and ends long after. Work done before the deal closes improves integration success, and monitoring for a sustained period allows the new entity to “settle in” to the GE portfolio. Acquiring a company most often represents a long-term commitment; the integration process should have a similar goal of long-term value creation. 2.Successful integration requires a committed team of talented professionals whose only job is integration. Integration managers, just like product or brand managers, create value for the business and require their own set of dedicated skills to succeed. Asking people to work on an integration team in addition to their already-full plates usually ends up with integration becoming a lower priority, which, in turn, jeopardizes the overall success of the acquisition. 3.Communication about important matters such as who will lose their jobs and how compensation systems will change must be clear, forceful, and immediate. People care a lot about their own future. Until they know where they stand, it's hard for them to commit to making the acquisition a true success. Only after people know WIFM (what's in it for me) will they attend to the strategic rationale for the move. 4.Real and significant integration happens best when people work together on real, mission critical tasks. Things like company picnics, “getting to know you” days, or other feel-good activities prove far less effective than assigning people to work on business-related, profit-generating activities. Working on real projects brings people together and helps the company show the success of the acquisition more quickly. Copyright © 2018, 2016 John Wiley & Sons, Inc. All rights reserved. 
Purchase answer to see full attachment