Market Scope

1
Market Scope

• Integration

2
3 Dimensions of Corporate Scope
Vertical Integration
Geography
Product Market
Source Collis and Montgomery, 1997
3
Global Product/Market Approach

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

4
International Expansion Tactics

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

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Global Efficiency vs. Local Responsiveness
High
High
Global Efficiency
3. Global Strategy
4. Transnational Strategy
Foreign Direct Investment
2. License/Franchise Distributor
1. Export Based
Low
Low
Low
High
Local Responsiveness
6
The Competitive Advantage of Nations, Michael
Porter, 1990
Firm Strategy, Structure, and Rivalry
Demand Conditions
Factor Conditions
Related and Supporting Industries
7
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.

8
Nobel Prize Winning Question

• Ronald Coase He trekked to America in the
  early 1930s 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)

9

• 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.

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Examples (causes) of market failures.
11
Market Failures Number of Buyers and Sellers

• 1. One Seller, One Buyer

12
Market Failures Difficulty in Writing Contracts

• 2. Contracts
• (Cocktail Party Words)
• Bounded Rationality
• Opportunism
• Pre Adverse Selection
• Post - Moral Hazard

13
Market Failures Asset Specificity

• 3. Asset Specificity

14
Market Failures - Frequency of Transaction

• 4. The more frequent a transaction, all else
  equal, the more likely integration will occur.

15
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.

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Solutions to Market Failure

• 1. Market Governance
• 2. Intermediate Governance
• 3. Hierarchical Governance (Vertical Integration)

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A Typology of Governance Mechanisms
18
Advantages of Increased Scope
Corporate Scope
Sharing Facilities Technology
Commonalities Customers Channels
Business Unit Competitive Advantage
19
Corporate Diversification
Unrelated Businesses
Related Businesses
Core Business
20
Why do firms diversify?

• 1. Economies of Scope
• Economies of scope create efficiencies from
  diversification.

21
Why do firms diversify?

• 2. Synergism 2 2 5

22
Why do firms diversify?

• 3. Market Power
• 4. Profit Stability

23
Why do firms diversify?

• 5. Diversification for Managerial Risk

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25
Mergers and Acquisitions

• Evaluation Criteria
• 1. Financial Logic
• 2. Strategic Logic

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• 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 the 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 predea1 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.
• MA NEEDN'T BE A LOSER'S GAME. By Selden, Larry,
  Colvin, Geoffrey, Harvard Business Review,
  00178012, Jun2003, Vol. 81, Issue 6

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Financial Logic
28
Financial Logic

• Problems
• Understanding ROIC
• Bidding and Auction Challenges
• Market Efficiency and Market Price

29
Empirical Evidence on Mergers and Acquisitions
30
Negative Empirical Explanations

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

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The Winners Curse

• The Lemons Problem

32
The Winners Curse

• Mergers and Acquisitions

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The Hubris Hypothesis
34
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.

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Strategic Logic

• Valuable, Rare, and Private Economies of Scope
  Imperfectly Competitive Market
• Microsofts purchase of Seattle Computer Products
  QDos for 50,000.

37
Strategic Logic

• Valuable, Rare, Costly to Imitate Economies of
  Scope
• Google To Acquire YouTube 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)

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Strategic Logic Rules for Bidding Firm Managers

• Search for valuable and rare economies of scope.
• Keep information away from other bidders.
• Keep information away from targets.
• Avoid winning bidding wars.
• Close the deal quickly.
• Operate in thinly traded acquisition markets.
• (Strategic Management and Competitive Advantage
  Concepts and Cases, 2006. Barney and Hesterly,
  Pearson Prentice Hall.)

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The Exception to the Rule

• BERKSHIRE HATHAWAY INC.

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A Third ChoiceStrategic 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.

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Strategic Alliances

• A. Characteristics
• defined period of time
• defined set of tasks
• "neither market nor hierarchy"

42
Strategic Alliances

• B. Benefits of alliances
• fast and flexible
• easier to start or stop
• political necessity