Market Scope Integration 3 Dimensions of Corporate Scope

Market Scope Integration

3 Dimensions of Corporate Scope Vertical Integration Geography Product Market Source: Collis and Montgomery, 1997

Fundamental Global Strategy Questions 1. What is your global strategy? 2. What foreign markets should you enter? 3. How should your enter a foreign market? 4. How will you implement (manage and lead) your foreign strategy and organization?

Global Product/Market Approach Multidomestic Product/Market Strategy n n Handle product design, assembly and marketing on a countryby-country basis Custom tailored products and services for particular markets (local responsiveness) Global Product/Market Strategy n n n One product design Marketing in the same fashion throughout the world Emphasis on efficiency Transnational Product/Market Strategy n n Entails seeking both global efficiency and local responsiveness Integrated network that fosters shared vision and resources while allowing for individual decisions

Global Efficiency vs. Local Responsiveness High Global Efficiency Low 3. Global Strategy 1. Export Based Low 4. Transnational Strategy Foreign Direct Investment 2. License/Franchise Distributor Local Responsiveness Low High

Understanding Institutions • Institutions: Definitions “Humanly devised constraints that structure human interaction” (North) “Regulatory, normative, and cognitive structures and activities that provide stability and meaning to social behavior” (Scott) Formal – laws, regulations, rules Informal – norms, cultures, ethics

Institutions, Firms, and Strategic Choices Copyright © 2009 Cengage. All rights reserved. Figure 4. 4 4– 7

A Comprehensive Model of Foreign Market Entries Copyright © 2009 Cengage. All rights reserved. Figure 6. 2 6– 8

The Competitive Advantage of Nations, Michael Porter, 1990 Firm Strategy, Structure, and Rivalry Factor Conditions Demand Conditions Related and Supporting Industries

International Expansion Tactics Exporting Contractual Arrangements n n Licensing Franchising Foreign Direct Investment n n n Joint Venture Wholly Owned Subsidiary Acquisition In general, moving down the list (above) is associated with greater cost, financial risk, profit potential and control

I. Vertical Integration Defined: Vertical integration is simply a means of coordinating the different stages of an industry chain when bilateral trading is not beneficial. (Stuckey and White, 1993, Sloan Management Review, Spring: 71 -82. ) The degree of vertical integration is one of the decision variables of an organization.

Nobel Prize Winning Question Ronald Coase: “He trekked to America in the early 1930 s on a scholarship, and wandered about the industrial heartland researching the methods of business firms. Coase's scientific methodology? He asked businessmen why they did what they did. One key question, for instance, involved why firms chose to produce some of their own inputs (vertical integration), and why they sometimes chose to use the market (buying from independent suppliers). He was fascinated by their answers, but even more by their astute calculation: Firm managers were keenly aware of all the relevant trade-offs. ” (http: //www. reason. com/9701/int. coase. html)

Question: If markets are efficient, then why is economic activity being organized within and among (costly) formal hierarchical structures using explicit planning and directives? Answer: Sometimes markets fail. A vertical market "fails" when transactions within it are too risky and the contracts designed to overcome these risks are too costly (or impossible) to write and administer.

Examples (causes) of “market failures. ”

Market Failures – Number of Buyers and Sellers 1. One Seller, One Buyer

Market Failures – Difficulty in Writing Contracts 2. Contracts n n n (Cocktail Party Words) Bounded Rationality Opportunism Pre – Adverse Selection Post - Moral Hazard

Market Failures – Asset Specificity 3. Asset Specificity

Market Failures - Frequency of Transaction 4. The more frequent a transaction, all else equal, the more likely integration will occur.

Solutions to Market Failure Ronald Coase (1937) introduced and Williamson (1985) developed the argument that by vertically integrating a firm opts to make its resource decisions internally, using whatever management mechanisms are available, as opposed to using the market to direct resources. The objective is to adopt the organizational mode that best economizes on transaction costs, minimizes the risk of market failure, while taking into account the expense of governance costs. Firms must balance transaction costs with the cost of governance.

Solutions to Market Failure 1. Market Governance 2. Intermediate Governance 3. Hierarchical Governance (Vertical Integration)

A Typology of Governance Mechanisms Devices Not Vertically Integrated Devices Spot-market Contracts Internal Markets Complete Contingent Claims Contracts Bureaucracy Sequential Contracting Clan Governance Relational Contracting

Advantages of Increased Scope Corporate Scope Sharing: Facilities Technology Commonalities: Customers Channels Business Unit Competitive Advantage

Corporate Diversification Core Business Related Businesses Unrelated Businesses

Why do firms diversify? 1. Economies of Scope n Economies of scope create efficiencies from diversification.

Why do firms diversify? 2. Synergism: 2 + 2 = 5

Why do firms diversify? 3. Market Power 4. Profit Stability

Why do firms diversify? 5. Diversification for Managerial Risk

6. Diversification for Growth – Portfolio Management Relative Market Share Market Growth Rate High Low

Mergers and Acquisitions Evaluation Criteria: 1. Financial Logic 2. Strategic Logic

Look at the Balance Sheet In evaluating potential acquisitions, companies must look beyond the lure of profits the income statement promises and examine the balance sheet, where the company keeps track of capital. It's ignoring the balance sheet that causes so many acquisitions to destroy shareholders' wealth. Unfortunately, most companies never look there. Managers see sales and profits going up, never realizing that they've put in motion a plan that will do great harm. To see how this works, imagine a company with the following financials. (See the exhibit "A Target: Before and After. ") It has sales of $1 billion and costs of $900 million, meaning it has an after-tax operating profit of $100 million. But that's not its real bottom line, of course. A business's true bottom line is its economic profit, which takes into account a charge for the money invested in it. Economic profit is simply the net operating profit ($100 million in this case) minus an appropriate charge for capital. The charge is determined by applying the company's cost of capital (we assumed 10%) to its total invested capital ($500 million). Subtracting that leaves an economic profit of $50 million. Let's assume further that this is a growing company and that Wall Street has rewarded it with a market value of $2 billion, which implies a price-to-earnings ratio of 20. (We've made the simplifying assumption that the company has no debt. ) Since the company has invested only $500 million in capital, it has done what all companies are supposed to do: It has created share-owner value, in this case $1. 5 billion worth. Now suppose you want to buy this company. Acquirers almost always pay a premium over the market value of a company, known as a control premium, on theory that it's worth more to control a company than to own a small stake and go along for the ride. A 50% premium is not out of line for an attractive target; for this company, that would mean a price of $3 billion. If you buy it for that price and do nothing to change its operations, here's what happens. Revenues, costs, net operating profit after tax, and preacquisition invested capital remain the same; so does the cost of capital. Of course, when a publicly traded company gets bought by another company, its market value is no longer observable in the stock market. Still, the business has an "intrinsic value, " a term used by Warren Buffett to mean the value of a company based on its financial characteristics. As long as those characteristics don't change, the intrinsic value doesn't either. [ 1] If operating profits were all you looked at, the deal could seem attractive. For an acquirer with earnings of $300 million, this acquisition would increase profits by a huge 33% (that is, from $300 million before the acquisition to $400 million after, ignoring acquisition costs). Further, acquirers often claim they'll achieve cost synergies with their new acquisitions, increasing their profits even more. Suppose this buyer believed it could cut costs to the extent that the acquired company's profits would double above acquisition costs, to $200 million; then the profit jump would be a fantastic 67%. That's the perspective from the income statement, and it looks great. But now let's consider the balance sheet. The acquirer has invested $3 billion in the target company, so its profit of $100 million represents a tiny 3. 3% return on invested capital (ROIC) -- a huge comedown from the predea 1 20%. Even $200 million in cost-cutting synergies, which experience shows is unlikely, wouldn't repair the damage. The ROIC would still be just 6. 7% (a $200 million return on $3 billion of invested capital). Assuming investors are looking for at least a 10% return, this deal more than likely will destroy value for share owners of the acquiring company. M&A NEEDN'T BE A LOSER'S GAME. By: Selden, Larry, Colvin, Geoffrey, Harvard Business Review, 00178012, Jun 2003, Vol. 81, Issue 6

Financial Logic Before Acquisition Revenue After Proposed After Acquisition Synergies Required Acquisition Synergies $1, 000 Costs $900 $800 $400 Net operating profit after tax $100 $200 $600 Invested capital $500 $3, 000 Return on invested capital 20% 3. 30% 6. 7% 20. 0% Cost of capital 10% 10% $50 ($200) ($100) $300 20 20 Market value/intrinsic value $2, 000 $4, 000 $12, 000 Share-owner value creation $1, 500 ($1, 000) $1, 000 $9, 000 Economic profit Market Price to Earnings Ratio Acquisition Cost = Net Operating Profit * PE + Market Premium = ($100*20)*1. 5 = $3, 000 = Invested Capital

Financial Logic Problems: n n n Understanding ROIC Bidding and Auction Challenges Market Efficiency and Market Price

Empirical Evidence on Mergers and Acquisitions

Negative Empirical Explanations You are in a foreign country and meet a merchant who is selling a very attractive gem. You’ve purchased a few gems in your life, but are far from an expert. After some discussion, you make what you’re fairly sure is a low offer. The merchant quickly accepts, and the gem is yours. n How do you feel?

The Winner’s Curse The Lemons Problem

The Winner’s Curse Mergers and Acquisitions

The Hubris Hypothesis

The Hubris Hypothesis Decision makers in acquiring firms pay too much for their targets on average in the samples we observe. The samples, however, are not random. Potential bids are abandoned whenever the acquiring firm's valuation of the target turns up with a figure below the current price. Bids are rendered (only) when the valuation exceeds the current market price. If there really are no gains in takeovers, hubris is necessary to explain why managers do not abandon these bids also since reflection would suggest that such bids are likely to represent positive errors in valuation.

Strategic Logic Valuable, Rare, and Private Economies of Scope: Imperfectly Competitive Market n Microsoft’s purchase of Seattle Computer Products QDos for $50, 000.

Strategic Logic Valuable, Rare, Costly to Imitate Economies of Scope Google To Acquire You. Tube for $1. 65 Billion in Stock Combination Will Create New Opportunities for Users and Content Owners Everywhere “The acquisition combines one of the largest and fastest growing online video entertainment communities with Google's expertise in organizing information and creating new models for advertising on the Internet. The combined companies will focus on providing a better, more comprehensive experience for users interested in uploading, watching and sharing videos, and will offer new opportunities for professional content owners to distribute their work to reach a vast new audience. ” (Google Press Release, MOUNTAIN VIEW, Calif. , October 9, 2006)

Strategic Logic Rules for Bidding Firm Managers 1. Search for valuable and rare economies of scope. 2. Keep information away from other bidders. 3. Keep information away from targets. 4. Avoid winning bidding wars. 5. Close the deal quickly. 6. Operate in “thinly traded” acquisition markets. (Strategic Management and Competitive Advantage: Concepts and Cases, 2006. Barney and Hesterly, Pearson Prentice Hall. )

The Exception to the Rule BERKSHIRE HATHAWAY INC.

A Third Choice: Strategic Alliances Strategic alliance- defined to include any arrangement in which two or more firms combine resources outside of their market in order to accomplish a particular task or set of tasks.

Strategic Alliances A. Characteristics: n n n defined period of time defined set of tasks "neither market nor hierarchy"

Strategic Alliances B. Benefits of alliances n n n fast and flexible easier to start or stop political necessity