Corporate Strategy: Diversification, Acquisitions, and Internal New Ventures

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CHAPTER
10

Corporate Strategy: Diversification,
Acquisitions, and Internal New Ventures

SYNOPSIS OF CHAPTER

This chapter continues the discussion of corporate strategy that was begun in Chapter 9. Diversif
ication into more
than one business is the corporate
-
level strategy for growth. The corporation is treated as a portfolio of
investments, and diversification is seen as a way of further leveraging the firm’s distinctive competencies. The
role of diversific
ation in increasing firm profitability, through transferring or leveraging competencies, sharing
resources, managing multipoint competition, or leveraging general organizational competencies, is also discussed.

Next, the chapter deals with related and unre
lated diversification, the advantages and disadvantages of each
strategy. The limits of diversification are also described, including an extensive treatment of bureaucratic costs.
The chapter continues with a discussion of diversification efforts that lead

to value dissipation, rather than value
creation.

The remainder of the chapter describes three entry strategies for diversification: internal new ventures,
acquisitions, and joint ventures. In each section, the benefits and challenges of that entry strate
gy are listed, along
with suggestions about how to increase the chances of a successful implementation of that strategy. Finally,
diversification’s opposite, restructuring, is introduced and several exit strategies are described.

TEACHIN
G OBJECTIVES

1
.

Introduce students to concepts related to diversification, including the reasons why firms pursue
diversification.

2
.

Describe related and unrelated diversif
ication and the benefits and problems associated with each.

3
.

Summarize the limits of diversification with a focus on bureaucratic costs, and show how diversification
can lead to value dissipation, rather than value creatio
n.

4
.

Describe benefits, challenges, and implementation guidelines for the corporate
-
level strategy of internal
new ventures.

5
.

Describe benefits, challenges, and implementation guidelines fo
r the corporate
-
level strategy of
acquisitions.

6
.

Describe benefits, challenges, and implementation guidelines for the corporate
-
level strategy of joint
ventures.

7
.

Discuss the reasons why f
irms restructure, and illustrate several exit strategies.

OPENING CASE: TYCO I
NTERNATIONAL

From 1996 to 2001, the conglomerate Tyco International expanded rapidly, acquiring over 100 diverse businesses.
Tyco’s business model is to seek t
o consolidate a previously fragmented industry in each of the industries in
which it competes. Also, Tyco refuses to enter into risky hostile takeovers, instead looking for companies that
make basic products and have a strong market presence, but are less
profitable than their peers. The firm
thoroughly investigates each potential target and replaces top managers with its own team. After acquisition, cost
cutting becomes the focus, with incentives for executives whose units reach earnings objectives.

Tyco’s

stock underperforms, because investors are put off by the complexity of its financial reporting and its
heavy debt burden. Rumors that Tyco was conspiring with managers of the acquired firms to inflate Tyco’s

Chapter
10
: Corporate Strategy: Diversification, Acqui sitions, and I nternal New Ventures

119

Copyright © Houghton Mifflin Company. All rights reserved.

performance persist. CEO Kozlowski resigned af
ter being charged with tax evasion. John Fort, the new CEO,
spun off Tyco’s finance division, and used the cash to pay down debts. Whether he can find a source of
continuing profitability remains to be seen.

Teaching Note:

This case tells how Tyco’s acquis
ition strategy both brings benefits to the firm, as well as
introduces some potential weaknesses. For example, the very success of its acquisition strategy led to the high
debt that brought the stock price down. An interesting discussion for your class cou
ld be started, based on
questions about Tyco’s ethics. Persistent rumors of financial misdeeds, a CEO charged with tax evasion, and
obscure financial reporting all seem to point to ethical problems at Tyco. Do your students think that Tyco does in
fact hav
e an unethical organization culture? If no, how do they explain the rumors? If yes, can outside observers
(for example, potential investors) determine the nature of the ethical issues, and how?

LECTURE OUTLINE

I
.

Ove
rview

A
.

This chapter is the second chapter that deals with corporate strategy, and focuses on
diversification
,
the process of adding new businesses to the company that are distinct from its established operatio
ns.
Thus, a
diversified company

is involved in two or more distinct businesses.

B
.

Another focus is on the execution of a diversification strategy. This might take place through
internal
new venturing
, which is
starting a business from scratch;
acquisition,

or buying an existing business;
and
joint ventures

established with the help of a partner.

C
.

A third topic is
restructuring
, the opposite of diversification, in wh
ich a company reduces the scope
of its operations by exiting industries.

II
.

Expanding Beyond a Single Industry

A
.

Corporate
-
level managers identify which industries a com
pany should compete in to maximize long
-
run profitability.

1
.

Often, it is better to compete within a single industry.

a
.

One advantage of a single business corporation is the ability to focus more

resources and
attention on that one area.

b
.

Another advantage is that a firm sticks with what it knows and does best, and does not
risk making the mistake of moving into areas in which it has no distinctive competencies.

2
.

There are also disadvantages to a single
-
business strategy.

a
.

One disadvantage is the increased risk that comes from tying corporate profitability to
just one industry.

b
.

Another disadvantage is that a firm may miss out on opportunities to further leverage its
distinctive competencies.

B
.

One model of a corporation looks at the firm as a port
folio of distinctive competencies, rather than a
portfolio of products. Managers can then consider how to leverage those competencies.

C
.

Hamel and Prahalad claim that, once a firm has identified its current com
petencies, it should use a
matrix, such as the one presented in Figure 10.1, to establish an agenda for building and leveraging
competencies to create new businesses.


Show Transparency 62

Figure 10.1: Establishing a Competency Agenda

1
.

The lower left corner of the matrix represents the company’s current portfolio of competencies.
This quadrant is called “fill
-
in
-
the
-
blanks” because the recommended strategy here is to transfer
existing competencies in order to improve its po
sition in existing industries.

2
.

The upper left matrix quadrant is called “premier plus 10,” to suggest that managers must be
building new competencies today to ensure that the firm is a premier provider ten years from
now.

3
.

The lower left quadrant is “white spaces,” and it indicates the firm’s search for new industries
where its existing distinctive competencies could be deployed through diversification.

4
.

T
he upper left quadrant is referred to as “mega
-
opportunities,” and it represents opportunities
for entry into new industries where the company currently has none of the required
competencies.

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Chapter
10
: Corporate Strategy: Diversification, Acquisitions, and I nternal New Ventures


Copyright © Houghton Mifflin Company. All rights reserved.

5
.

Use of this matrix helps mana
gers think strategically about competencies and industries as they
change over time. Managers who use this matrix will be unlikely to enter new markets where
they do not have a competitive advantage.

D
.

Companie
s that wish to expand beyond a single industry must develop their business model at two
levels.

1
.

First, they must develop a business model for each industry in which they plan to compete.

2
.

Then, the company must develop a higher
-
level multibusiness model that justifies entry into
different industries in terms of profitability. This model should describe how the firm plans to
leverage its distinctive competencies across industries. The model

must also describe how the
business and corporate strategies boost profitability.

III
.

Increasing Profitability Through Diversification

A
.

Diversification
is the process
of adding new businesses to the company that are distinct from its
established operations. Thus, a
diversified company

is involved in two or more distinct businesses.

B
.

To increase profitability, diversificatio
n should allow the company to lower costs, differentiate its
products, or better manage industry rivalry.

C
.

When the firm is generating
free cash flow
, that is, profits about the level necessary to meet current

expenses and obligations, the firm’s managers may choose to return dividends to shareholders or to
invest the cash in diversification.

D
.

For diversification to make economic sense, the expected return on inves
ted capital (ROIC) from the
diversification must exceed the returns shareholders could realize through investing that capital in a
diversified investment portfolio.

1
.

One way that firms use diversification to boost profitab
ility is through their ability to transfer
their existing distinctive competencies to an existing business in another industry. The transfer
must involve competencies that are important for competitive advantage in that business.


Show Transparency 63

Figu
re 10.2: Transfer of Competencies at Philip Morris

2
.

Another way of boosting profitability requires that the company leverage its existing distinctive
competencies by using them to create a new business in a different indus
try.

a
.

Leveraging competencies involves creation of a new business, whereas transferring
competencies involves an existing business. This distinction is important because the two
different situations require

the use of different managerial skills.

b
.

Companies that leverage competencies tend to use R&D skills to build a new venture in a
technology
-
related industry, whereas companies that transfer competencies te
nd to
acquire established businesses.

STRATEGY IN ACTION 1
0.1: DIVERSIFICATION

AT 3M: LEVERAGING
TECHNOLOGY

3M is known for its ability to generate new products and new businesses

30 percent of its sales come from
products developed during the last five ye
ars. The company is consistently able to extend an existing
technological competency to making a similar yet innovative product. Their success is due to a variety of factors,
including a culture that encourages risk taking, a focus on solving customer prob
lems, the use of stretch goals, and
employee autonomy to pursue their own ideas. Also important are the firm’s system for sharing technologies and
expertise and a reward structure that recognizes innovators.

Teaching Note:

This case provides an example of
a firm that is skilled at leveraging existing competencies into
the creation of new businesses, but it’s especially useful that the specific mechanisms for encouraging innovation
are described in detail. Ask students to consider how another company with wh
ich they are familiar might use
some or all of 3M’s strategies for improving innovation. What would be some likely results?

3
.

Another way to use diversification to increase profitability is through sharing resources across
multiple businesses in order to obtain cost reductions. This sharing is called
economies of
scope
.


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a
.

Economies of scope occur because each business can invest less in the shared resource
than in resources that are not shared.


S
how Transparency 64

Figure 10.3: Sharing Resources at Procter & Gamble

b
.

Economies of scale generate economies of scope, because resource sharing allows the
company to use the resource more intensively.

c
.

Economies of scope are obtained only when there is significant commonality between
one or more value creation functions in the two businesses.

d
.

Also, managers must weigh the benefits obtained by resource sharing against th
e
increased bureaucratic costs of doing so.

4
.

Diversification can also boost profitability by enabling the company to better manage rivalry
through the use of multipoint competition.

a
.

Multipoint

competition

occurs when two companies rival each other in more than one
industry.

b
.

The threat of increasing competitive rivalry in one industry can keep a competitor from
entering another industry or can cause the competitor t
o lessen the intensity of
competitive pressure.

5
.

A final way that profitability can increase due to diversification is through the improved use of
general organizational competencies
, that is, corporate
-
level competencies
that transcend
individual functions or businesses.

a
.

General organizational competencies require the use of rare managerial skills and are
difficult to develop and implement.

b
.

One general organizational competency is an entrepreneurial capability, which allows
managers to recognize and develop new businesses internally. Companies with this
competency are skilled at encouraging risk taking while also limiting the a
mount of risk
undertaken.

c
.

Another general organizational competency is the ability to develop effective
organization structure and controls.

(
1
)

Effective structure and c
ontrols encourage business
-
level managers to maximize
efficiency and effectiveness, increasing profitability.

(
2
)

Companies with effective structure and controls tend to use self
-
contained business
divisions.

(
3
)

Companies with effective structure and controls tend to be decentralized.

(
4
)

Companies with effective structure and controls tend to link pay to performance.

d
.

Another general organizational competency is a superior strategic capability, such that
top managers have good governance skills and can effectively manage the firm’s
business
-
level managers.

(
1
)

One aspect of superior strategic capability is a flair for entrepreneurship.

(
2
)

Superior strategic capability also expresses itself in an ability to recognize ways to
improve the performance of indiv
iduals, functions, and businesses.

(
3
)

Another aspect of effective governance is the ability to diagnose the real source of
problems and then to know the appropriate steps to take to fix those problems.

(
4
)

Superior strategic capability is at work when a diversified company acquires a new
business and then restructures it to improve performance.

IV
.

Types of Diversification

A
.

Related

diversification

moves the company into a new activity that is linked to its existing activity
by a commonality between value chain activities.

1
.

Typically, the commona
lity lies in the manufacturing, marketing, and technology functions.

2
.

Typically, firms pursing a strategy of related diversification expect to benefit from transferring
and leveraging competencies and from sharing resource
s.

3
.

Also, companies pursing a strategy of related diversification are likely to encounter their rivals
in several related industries and thus are likely to benefit from managing that rivalry through
multipoint competition.

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Chapter
10
: Corporate Strategy: Diversification, Acquisitions, and I nternal New Ventures


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STRATEGY IN ACTION 1
0.2: RELATED DIVERSI
FICATION AT INTEL

Intel’s operations have been focused on microprocessors for personal computers, but when executives realized
that PC sales were reaching saturation and that communications would likely be the next
high
-
growth industry,
they turned the company’s attention to developing semiconductors for the communications industry. This switch
would allow the company to leverage their technological know
-
how more fully. From 1997 to 2001, Intel
acquired 18 chipmakers

and moved into fourth place in the industry, spending a total of $18 billion.
Unfortunately, the communications industry slumped and the business became a money
-
loser. In contrast, its PC
chips are still highly profitable and its competition position in t
hat industry seems assured.

Teaching Note:
This case gives an example of a not very successful foray into related diversification. Although
Intel executives expected to be able to leverage their competencies, the firm is still in a weak position in the
com
munications industry. You can use this case to illustrate the difficulties in identifying businesses that have
enough commonality to allow for successful leveraging of competencies. Also, now is a good time to ask students
for creative suggestions for rela
ted diversification in other firms. You can ask them, “What businesses are good
candidates for related diversification by Exxon?” “by Disney?” “by Wal
-
Mart?” and so on. As students debate the
merits of different potential targets, they will come to realize

how difficult identifying a good target can be.

B
.

Unrelated diversification

moves the company into a new activity that has no obvious commonalities
with any of the company’s existing activities.

1
.

Typically, firms expect to benefit from unrelated diversification through the exploitation of
general organizational competencies.

2
.

Typically, firms pursuing unrelated diversification are unlikely to m
eet their rivals in more than
one industry, and thus are unlikely to benefit from managing rivalry through multipoint
competition.

V
.

The Limits of Diversification

A
.

Dive
rsification, in many cases, can dissipate value instead of creating it.

1
.

Although related diversification has more ways to increase profitability and seems to involve
fewer risks, research has shown that

related firms achieve profits that are only slightly higher
than unrelated firms.

2
.

Firms that are extensively diversified, with many businesses, tend to be less profitable.

3
.

A study by Mi
chel Porter found that over time, companies divested many more of their
acquisitions than they kept.

B
.

One reason for the failure of diversification to achieve its goals is that the
bureaucratic costs

of
divers
ification exceed the value created by it.

1
.

The level of bureaucratic costs is a function of the number of businesses in a company’s
portfolio.

a
.

The greater the number of businesses, the more di
fficult it is for managers to remain
informed about the complexities of each business. They simply do not have the time to
process all the information.

(
1
)

Therefore, corporate
-
level managers end up making important dec
isions based on a
superficial analysis of each business.

(
2
)

Corporate managers’ lack of familiarity with operations increases the probability
that business
-
level managers will be able to distort information provided to

those at
the corporate level.

b
.

Thus, information overload can result in substantial inefficiencies within extensively
diversified companies.

c
.

In order to overcome information overload, some corpora
te managers limit the extent of
diversification at their firms.

2
.

Another source of bureaucratic costs is the coordination required to realize value from
transferring competencies and resource sharing.


Show Transparency 65

Figure 10.4: Coordination Among Related Business Units

a
.

Bureaucratic costs arise from an inability to identify the unique profit contribution of a
business unit that is sharing resources and functions with another unit.


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b
.

This problem can be resolved if corporate management directly audits both divisions,
however, doing so requires both time and effort from corporate managers.

c
.

The accountability problem is far more serio
us at companies that are extensively
diversified. Information overload occurs and corporate management effectively loses
control of the company.

3
.

Thus, bureaucratic costs, which increase as a function of the number of busi
nesses and the
extent of resource sharing, place a limit on the value created by diversification. If a company
continues to diversify after the point at which costs exceed benefits, profitability will decline.
Then, divestment is the best solution.

C
.

Another reason that companies fail to realize the expected benefits of a diversification is that
companies make an inappropriate choice between related and unrelated diversification.

1
.

Although the ways that related diversified companies can create value are more numerous, the
bureaucratic costs of a related strategy are higher than those of an unrelated strategy. Thus,
related firms may be no more profitable than unrelated firms.

2
.

Related diversification should be chosen when the firm’s distinctive competencies in its core
business have commonalities with the competencies required to compete in other businesses,
and when
the bureau
cratic costs of implementation do not exceed the value created through
resource sharing.

3
.

A company should pursue unrelated diversification when
its distinctive competencies are highly
specialized and
have few applications outside the core business, when top management
possesses super strategic capabilities, and when the bureaucratic costs of implementation do not
exceed the value created through restructuring.

D
.

Another reason for the failure of a diversification strategy to meet its objectives is that

many
companies diversify for the wrong reasons, and end up dissipating value rather than creating it.

1
.

One inappropriate reason for diversification is to pool risk.

a
.

Risk pooling is said to create a more stable income stream, reducing the risk of
bankruptcy, which is in the best interests of stockholders.

b
.

However,
this argument ignores two facts.

(
1
)

Stockholders can easily eliminate the risks inherent in holding an individual stock
by diversifying their own portfolios, and they can do so at
a much lower cost than
the company can.

(
2
)

Research shows that corporate diversification is not a very effective way to pool
risks. The business cycles of different industries are not easy to predict and in any
case te
nd to be a less important influence on share price than a general economic
downturn, which hits all industries simultaneously.

2
.

A second inappropriate reason to diversify is to
achieve greater growth.
Such diversification is
not a coherent strategy because growth on its own does not create value, despite the fact that
empire
-
building top executives sometimes pursue growth for its own sake.

VI
.

Entry Strategy: Inte
rnal New Ventures

A
.

Internal new venturing is one method that companies can use to execute a corporate
-
level
diversification strategy.

B
.

Internal new venturing is a
n appropriate strategy to use for several reasons.

1
.

Internal new venturing is used when a company possesses a set of valuable competencies in its
existing businesses that can be leveraged or recombined to enter the new bus
iness area.

2
.

Science
-
based companies that use their technology to create market opportunities in related
areas tend to favor internal new internal venturing.

3
.

Even if it lacks the competen
cies required to compete in a new business area, a company may
use internal new venturing to enter a newly emerging or embryonic industry where there are no
established players that possess the competencies required to compete in that industry. Thus,
inter
nal new venturing is the only option.

C
.

There are some drawbacks to the use of internal new ventures, which have a very high failure rate.

1
.

Large
-
scale entry into a new busines
s is more likely to be successful than is small
-
scale entry,
because it entails greater short
-
term costs, but gives greater returns in the long run. This is due
to the greater economies of scale, brand loyalty, and access to distribution channels that larg
e
firms enjoy. The effect is especially noticeable when a firm is entering an established industry
with powerful incumbents.

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: Corporate Strategy: Diversification, Acquisitions, and I nternal New Ventures


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Show Transparency 66

Figure 10.5: Scale of Entry, Profitability, and Cash Flow

2
.

Another concern w
ith internal new ventures is that a company can become blinded by the
technological possibilities of a new product and fail to analyze market opportunities properly,
leading to poor commercialization. Successful commercialization requires that there be a
m
arket demand for the technology.

3
.

Internal new ventures can also fail due to a poor implementation. Common mistakes here
include pursuit of too many ventures at once leading to strained resources, failure to ensure the
str
ategic value of the venture beforehand, and failure to anticipate the tie
-
and
-
cost demands

leading to an unrealistic profit expectation.

D
.

To avoid the above pitfalls, managers can follow a number of guidelines

to reduce the risk of new
venture failure.

1
.

A company should use a structured approach to new venture development, including both
exploratory (basic) research and development research.

a
.

Good b
asic research comes from strong ties to university research communities and from
giving researchers enough resources to pursue “blue
-
sky” projects of their own choosing.

b
.

However, basic research alone will not lead a successful

commercial venture.

c
.

Good development research also requires resources to be given to business
-
level
managers, who are ideally situated to recognize commercially viable technologies.

d
.

Good developm
ent research also requires communicating company strategies and goals to
researchers, so that their research will be relevant to those goals.

2
.

Another way to increase the probability of new venture success is to foster clo
se links between
R&D and marketing
and

R&D and manufacturing.

a
.

Project teams with members from the various functional areas are an effective way to
foster close links.

b
.

These teams can also signific
antly reduce product development time.

3
.

Another strategy is to devise a selection process for choosing only the ventures that demonstrate
the greatest probability of commercial success.

4
.

T
o ensure success, managers must also monitor the new venture closely, focusing on market
share rather than on profit goals for the first few years. Large market share facilitates economies
of scale and learning effects, which will ultimately lead to superi
or profitability.

5
.

Finally, companies can help to ensure new venture success by thinking big. They should look
for products that have high potential demand, construct efficient
-
scale manufacturing plants
ahead of need, and

spend generously on marketing. These steps will help to lead to high market
share and profitability.

VII
.

Entry Strategy: Acquisitions

A
.

Acquisitions are the main strate
gy for implementing horizontal integration, and they are also used in
vertical integration and diversification strategies.

B
.

Acquisition is an appropriate strategy to use for several reasons.

1
.

A company can use acquisition to enter a new business area when they lack important
competencies required in that area, and they can purchase an incumbent company that has those
competencies at a reasonable price.

2
.

Acquisition is a quick way to establish a significant market presence and generate profitability.

3
.

Acquisitions are perceived to be somewhat less risky than internal new ventures, because they
involve less uncert
ainty. When a company makes an acquisition, it is acquiring known
profitability, revenues, and market share; thus it reduces uncertainty.

4
.

Acquisition is a good entry mode when the industry to be entered is well establishe
d with high
barriers to entry. The greater the barriers to entry, the more likely it is that acquisitions will be
the favored entry mode.

C
.

There are some drawbacks to the use of acquisition, which have a high failure rate and of
ten dissipate
value instead of creating it.

1
.

A challenge for acquiring firms is to smooth postacquisition integration of the two companies.
Unanticipated problems often occur when an attempt is made to m
arry two divergent corporate
cultures. This can lead to high management turnover and can depress profitability.


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STRATEGY IN ACTION 1
0.3: POSTACQUISITION

PROBLEMS AT MELLON B
ANK

In 1993 Mellon Bank acquired Boston Co., a money management firm for major inst
itutional clients, for $1.45
billion. Problems at Boston Co. began to surface soon after the acquisition. From the start there was a clash of
cultures

Mellon’s culture is based on frugality and top
-
down control, whereas Boston Co. employees expected
autono
my and high pay. Mellon cut Boston’s expenses and increased rules and restrictions. When a Boston Co.
portfolio experienced low returns, Mellon managers liquidated it, taking a $130
-
million charge against earnings
and firing the portfolio manager, for “una
uthorized trades.” Infuriated by what they saw as Mellon’s interference,
seven Boston Co. managers proposed a management buyout. When Mellon rejected the proposal, some high
-
profile Boston Co. managers left, taking valuable employees and clients with them.

Teaching Note:
The problems at Mellon and Boston are yet another example of how difficult it can be to merge
two divergent corporate cultures, and how the management turnover that results from such attempts can deal a
serious blow to any attempt to create

value out of an acquisition. Ask students to suggest how Mellon might have
avoided or mitigated some of these problems.

2
.

Another challenge is that companies often overestimate the potential for creating value by
joining t
ogether different businesses. They overestimate the strategic advantages of the
acquisition and thus overpay for the target company. Richard Roll attributes this to top
management hubris.

3
.

Another drawback relates to the p
rice of a
cquisitions, which tend to be very expensive.
Stockholders of the target company do not want to sell unless they are offered a premium price.
In addition, several bidders are sometimes pursuing the same target company, bidding up the
price to resu
lt in a typical increase in market value of 40 to 80 percent.

STRATEGY IN ACTION 1
0.4: JDS UNIPHASE’S
$40 BILLION ERROR

JDS Uniphase was doing a booming business in optical gear, but couldn’t increase capacity fast enough to handle
the growing demand. So f
rom November 1999 to July 2000, the firm made three acquisitions, financing them with
issuance of JDS stock. When demand collapsed in early 2001, it became clear that the firm paid too much for the
acquisitions and the company had to write down the value o
f intangible assets, reducing earnings by $44.8 billion.
No “real” money was lost and the write down left the company in a sound financial position. However,
shareholders saw the stock price decline from a high of over $150 in March 2000 to under $2 in Sep
tember 2002.

Teaching Note:

This case illustrates yet another drawback to acquisitions, which is that an accurate valuation can
be very difficult to achieve, especially when the reasons for the acquisition are not wholly rational, as in this case.

4
.

Another drawback is that, when firms overpay for the acquisition, the resulting debt can depress
company profits.

5
.

Yet another drawback is that many companies make acquisition decisions without t
horoughly
analyzing the potential benefits and costs. As a consequence, after the acquisition is complete,
many acquiring companies find that they have purchased a troubled organization instead of a
well
-
run business.

D
.

To avoid the above pitfalls, managers can follow a number of guidelines to reduce the risk of
acquisition failure.

1
.

Thorough screening of acquisition targets leads to a more realistic assessm
ent of the costs and
benefits of an acquisition.

a
.

The company should begin with an assessment of the strategic rationale for the
acquisition and identify the types of companies that would make good candidates.

b
.

Next, the company should scan the target population, assessing such items as finances,
management capabilities, and corporate culture.

c
.

Then, favorable targets should be identified and evaluated more thoroughly. Th
is may
involve talking to third parties, as well as performing a detailed audit, if the acquisition is
a friendly one.

2
.

Good bidding strategy help to reduce risk because it can reduce the price of an acquisition.

a
.

Friendly takeovers are more likely to have a favorable price.

b
.

The timing of the acquisition is also important. Essentially sound businesses that are
suffering from short
-
term or localized problems are usua
lly undervalued.

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Copyright © Houghton Mifflin Company. All rights reserved.

3
.

Taking positive steps to quickly integrate the acquired business into the company’s
organizational structure is also key to an acquisition’s success.

a
.

Int
egration should focus on the source of the expected competitive advantages.

b
.

Integration should be accompanied by elimination of any duplication of assets or
functions.

4
.

Acquirers should also t
ake steps to learn from previous experience with acquisitions.

VIII
.

Entry Strategy: Joint Ventures

A
.

Joint ventures are used as a diversification mode less frequently th
an are internal new ventures and
acquisitions.

B
.

Joint venture is an appropriate strategy to use for several reasons.

1
.

Joint ventures are particularly appealing when a firm wis
hes to enter an embryonic or emerging
market, but hesitates to commit the resources. Joint ventures allow two or more companies to
share the risks of a new business.

2
.

Companies use joint ventures when they possess some of
the skills and assets needed by the
new business, but not all. They can team up with a firm with complementary skills to increase
the probability of success.

C
.

There are some drawbacks to the use of joint ventures.

1
.

Although a joint venture allows a company to share the risks and costs of developing a new
business, it also means that it must share the profits if the new business is successful.

2
.

By definition, in the case of a joint venture, control must be shared with the venture partner.
This can lead to substantial problems if the two companies have different business philosophies,
time horizons, or investment preferences. Conflicts over how to

run the joint venture can tear it
apart and result in business failure.

3
.

When a company enters into a joint venture, it always runs the risk of giving away critical
know
-
how to its joint
-
venture partner.

IX
.

Restructuring

A
.

Restructuring, or strategies for reducing the scope of the company by exiting from business areas, is
the opposite of diversification, which increa
ses scope.

B
.

Restructuring is becoming increasingly popular among firms that diversified in the 1980s and 1990s.

C
.

Restructuring occurs in response to several facto
rs.

1
.

In recent years, investors have assigned a
diversification discount

to highly diversified
companies, meaning that their stock was undervalued as compared to the stock of less
diversified firms.

a
.

Investors are deterred by the complexity and lack of transparency in the financial
statements of highly diversified firms, leading to an increased risk for the investment.

b
.

Investors have learned from experience that man
y companies overdiversify, or diversify
for the wrong reasons, leading to lower profitability.

c
.

Therefore, companies have restructured in order to split the company and increase returns
to shareholders.

2
.

Restructuring can be a response to failed acquisitions.

3
.

Due to innovations in management processes and strategies, the advantages of being vertically
integrated or diversified have diminished, and so companies
are restructuring.

D
.

Companies use a variety of strategies to implement restructuring, that is, to exit a business.

1
.

Divestment

is the best way for a company to recoup as much
of its initial investment in a
business as possible. The idea is to sell the business unit to the highest bidder. There are three
types of buyers.

a
.

Selling a business to independent investors is referred to as a
spinoff
. A spin
off makes
good sense when the unit to be sold is profitable and the stock market is looking for new
stock issues.

b
.

Selling off a unit to another company is another strategy. The buyer is often a competitor
in the same line of b
usiness. In such cases, the purchaser may pay a considerable amount
of money for the opportunity to substantially increase the size of its business
immediately.

c
.

Selling off a unit to its management is normally referred to as a

management buyout

(MBO)
. In an MBO, management finances the purchase through the sale of high
-
yield

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127

Copyright © Houghton Mifflin Company. All rights reserved.

bonds to investors. In recent years, the lack of investors interested in high
-
yield, high
-
risk
bonds (also called junk bonds), has made it difficult to car
ry out any MBOs.

2
.

A harvest

strategy is implemented when a company ceases investment in a business, but
continues to “harvest” profits from it for as long as possible.

a
.

Although this strategy s
ounds nice in theory, it is often a poor one to pursue in practice
because the morale of the unit’s employees, as well as the confidence of the business’s
customers and suppliers in its continuing operation, can all decline rapidly once it
becomes apparent

that the business is pursuing a harvest strategy.

b
.

Therefore, the rapid decline in the business’s revenues can make the strategy untenable.
This strategy is thus much less desirable than a divestment strategy.

3
.

A liquidation strategy requires a company to cease operations in that business and sell its assets.

a
.

A liquidation strategy is the least attractive of all to pursue because the company has
to
write off its investment in a business unit

often at a considerable cost.

b
.

Liquidation is much less desirable than either a divestment or a harvest strategy.

c
.

More information about harvest and liquidation strategies is available in Chapter 6, in the
final section that discusses strategies for declining industries.

ANSWERS TO DISCUSSIO
N QUESTIONS

1
.

When is a
company likely to choose related diversification and when unrelated diversification? Discuss
with reference to an electronics manufacturer and an ocean
-
shipping company.

Related diversification will be favored when there are significant commonalities betwe
en the skills of the
company’s core businesses and the skills needed to compete in other business areas. Also, companies will
use related diversification when the benefits of resource sharing and skill transfers outweigh the costs of
implementation. Finall
y, companies prefer related diversification when it can help them prevail in
multipoint competition.

Unrelated diversification will be favored under exactly the opposite conditions: when there are few
commonalities, when the costs outweigh the benefits, an
d when the company is not involved in multipoint
competition.

With regard to an electronics manufacturer, electronics skills are central to many of today’s industries. Thus
related diversification opportunities are many for companies based in the electroni
cs industry. In contrast,
the skills needed to run a shipping line bear no obvious relationship to the skills needed to run other
businesses

even other transport businesses. Therefore, related diversification opportunities are fewer, and
such companies ten
d to pursue a strategy of unrelated diversification.

2
.

Under what circumstances might it be best to enter a new business area by acquisition, and under what
circumstances might internal new venturing be the preferred entry
mode?

Acquisitions tend to make most sense when barriers to entry are high, that is, the costs of internal venturing
are high. Also, acquisitions are preferred when the company is pursuing unrelated diversification, because
acquisitions provide instant acc
ess to an experienced management team, reducing learning costs. Third,
acquisitions make more sense when the acquiring company is unwilling to accept the commitment of time,
the development costs, and the risks of internal venturing.

Internal new venturing

makes sense in the opposite circumstances, that is when barriers to entry are low,
when the industry to be entered is closely related to the company’s existing operations, and when the
company does not need to move quickly and can accept a relatively low
probability of success.

3
.

Imagine that
IBM has decided to diversify into the cellular telecommunication provider business. What
entry strategy would you recommend the company pursue? Why?

There is no one right answer to thi
s question. Rather, it calls for students to demonstrate knowledge of the
pros and cons of acquisitions, relative to internal ventures and joint ventures, as alternative entry strategies.
In reality, if IBM did decide to enter into the cellular telecommuni
cation business, it would probably use a
combination of entry strategies. It might try to gain access to some critical competencies by (a) acquiring
firms that possess those competencies and/or (b) entering into strategic alliances (joint ventures) with su
ch
firms. In addition, the company might well use its own digital know
-
how to build the businesses.

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Copyright © Houghton Mifflin Company. All rights reserved.

4
.

Look at Honeywell’s portfolio of businesses (described in Honeywell’s 10K statements which can be
accessed on the web at
www.honeywell.com). How many different industries is Honeywell involved in?
Would you describe Honeywell as a related or unrelated diversification company? How do you think that
Honeywell’s diversification strategy increases profitability?

Honeywell is inv
olved in hundreds of businesses, focused on four major sectors: aerospace, automation and
control systems, specialty materials, and transportation and power systems. Honeywell’s business are not
purely related or unrelated. They share some common traits, s
uch as a reliance on electronics and
engineering know
-
how, but they also are unrelated in the customer segments they serve and the
manufacturing technologies they use. By organizing their hundreds of products into just four sectors,
Honeywell is able to of
fer a bundle of related products to customers within each segment. Across segments,
Honeywell primarily benefits from reducing duplication in corporate functions, such as payroll.
Honeywell’s size also leads to increase brand name reputation. Finally, Hone
ywell benefits to some extent
from sharing knowledge across segments.

SMALL
-
GROUP EXERCISE: DUN
& BRADSTREET

Students are asked to break into small groups and read a short news release from Dun & Bradstreet. They are then
asked to descri
be why the split took place, and how it might affect the performance of the three successor
companies. They must answer the questions, “If you were a stockholder in the old Dun & Bradstreet Corporation,
would you approve of this split? Why?”

Teaching Note:

D&B is divesting itself of diversified activities in order to concentrate on its core business. One
reason for the restructuring might be that Dun & Bradstreet might find its core business areas under attack from
new competition due to changes in technolo
gy. Another reason might be that the top management at Dun &
Bradstreet spread itself too thin to coordinate the diverse business portfolio.

Dun & Bradstreet chooses to sell off two companies to shareholders. A spinoff makes good sense when the unit to
be
sold is profitable and when the stock market has an appetite for new stock issues (which is normal during
market upswings, but not during market downswings). The split is likely to have a positive impact on the earnings
of all three successors.

There is no

right or wrong answer to the question whether one would approve of the split being a shareholder. A
close look at the three new proposed companies makes it difficult to identify Dun & Bradstreet’s core business;
e.g., the new Dun & Bradstreet group includ
es financial as well as marketing information services; the Cognizant
Corporation and A. C. Nielson also provide marketing information services. Perhaps a split into two companies
providing financial services on the one hand and marketing services on the o
ther might have been more beneficial.

ARTICLE FILE 10

Students should find an example of a company that has made an acquisition that appears to have failed to create
any value. Have them identify and critically evaluate the rationale use
d by top management to justify the
acquisition when it was originally made. Students should also determine why the acquisition subsequently failed.

Teaching Note:

You will probably have to identify for students some useful examples. Firms with failed
acqui
sitions might include the railroad merger of Union Pacific and Southern Pacific, Quaker Oat’s acquisition of
Snapple, AT&T’s acquisition of NCR, Sara Lee’s acquisitions of Coach leather goods and Electrolux vacuums,
and so on. As they examine these or othe
r cases of failed acquisitions, students will quickly realize that managers’
estimates of projected benefits can often be quite inaccurate, and they are often far too optimistic as they choose a
partner, set a price, and attempt to integrate the firms afte
r the acquisition.

STRATEGIC MANAGEMENT

PROJECT: MODULE 10

This module requires students to assess their company’s use of acquisitions, internal new ventures, and joint
ventures as strategies for entering a new business area and or as at
tempts to restructure its portfolio of businesses.
For companies that have recently entered a new business, students are asked to identify and evaluate the reasons
and strategy used by the company. They are then asked to determine whether the diversificati
on added value to
the corporation. For companies that have recently reduced diversification through restructuring, students are asked
to identify the reasons and exit strategy used, and then to evaluate the effectiveness of the restructuring efforts.


Chapter
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Copyright © Houghton Mifflin Company. All rights reserved.

Teach
ing Note:

Every large corporation will have a history of growth that will involve the use of one or more of
these growth strategies, and most will have a history of restructuring attempts. Students should be encouraged to
think about their responses and id
entify relationships. For example, if a firm is restructuring in order to respond to
a failed acquisition, the acquired firm may be an attractive target for a corporate buyer, and thus the firm would
probably use divestment, rather than harvest or liquidat
ion strategies.

EXPLORING THE WEB: V
ISITING GENERAL ELEC
TRIC

Students are asked to visit the web site of General Electric (www.ge.com) and to review GE’s portfolio of
business. They are asked to evaluate whether the portfolio creates val
ue, to suggest changes, and to describe GE’s
distinctive competencies and how they leverage them. In the General Task, students are asked to identify a
company that has recently restructured its portfolio of businesses, and then identify and evaluate the s
trategic
rationale behind this restructuring.

Teaching Note:

GE organizes its business units into home products, including appliances, lighting, home comfort
and safety, and adhesives and sealants. Another unit is the business products, which include produ
cts for
automotive, building and construction, health care, retail, telecommunications, transportation, and utilities
industries. Some students may feel that this portfolio creates value, by leveraging engineering competencies,
whereas others may feel that

is overly diversified, resulting in an unrelated diversification that adds little value.

In the General Task, students may have trouble finding a firm that has recently undergone restructuring. You can
recommend firms such as Kmart, Nortel, Lucent, Qwest,

and Vivendi. From this exercise, they will gain further
appreciation of the complexities and considerations that are necessary in planning a diversification or
restructuring move.

CLOSING CASE: THE CH
ANGING BOUNDARIES OF

AT&T, 1995

2002

In 1995, AT&T underwent one of the largest restructurings of any U.S. firm. It split into three distinct businesses:
AT&T retained the firm’s long
-
distance and wireless businesses, Lucent was the name of the newly
-
formed
network equipment business, and AT
&T Global Information Solutions was formed around NCR, an earlier
acquisition, to manufacture computer systems. The restructuring was inspired by regulator and competitive
changes in AT&T’s industries. Also the combination of communications, networking, an
d computers generated
internal and external conflicts of interest, as AT&T was selling products to its competitors in other industries,
among other complicating factors. In addition, AT&T hoped to rid itself of a failed acquisition in an increasingly
tough

industry.

As soon as the spin off was completed, AT&T purchased cable providers TCI and Media One. AT&T hoped to
use their cable networks to handle phone calls, saving the firm the fees it was paying to local providers. However,
the cable systems could no
t be upgraded for phone calls quickly or cheaply, and so AT&T sold those units just a
few months later.

Teaching Note:

This case shows that even firms with a great deal of experience in acquisitions and restructuring,
continue to have difficulties in creat
ing just the right portfolio. AT&T will undoubtedly continue to struggle with
this problem for some time to come.

Answers to Case Discussion Questions

1
.

What changes in AT&T’s operating

environment triggered its 1995 decision to break the company up into
three entities?

The change in AT&T’s strategy was triggered by several changes that took place in its operating
environment. First, there was the impending deregulation of the U.S. telec
ommunications industry. Second,
state
-
owned telephone companies around the world were privatized. Third, there was a rapid change in the
telecommunications business as new technologies, such as wireless communications and the Internet,
created significant
opportunities and threats for AT&T. Thus, AT&T had decided that these changes taking
place in its operating environment gave rise to significant new business opportunities in its core
telecommunications business

such as the opportunity to create wireless a
nd global telephone networks.
Accordingly, AT&T decided to restructure the company, focusing on telecommunications services and
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: Corporate Strategy: Diversification, Acquisitions, and I nternal New Ventures


Copyright © Houghton Mifflin Company. All rights reserved.

exiting from the computer and network equipment businesses by spinning off these operations to
independent investors.

2
.

How might the breakup create value for shareholders?

The breakup created some value for shareholders. AT&T has done well. Lucent Technologies had an early
period of high performance, which has dampened somewhat as demand for networ
king equipment is down.
On the other hand, AT&T Global Information Systems has seen performance fall even further since the
breakup.

3
.

Does the 1995 breakup imply that AT&T’s pre
-
1995 strategic vision was seriously flawed?

Not necessarily. AT&T’s strategy was probably justifiable during the 1980s and early 1990s, even though
its venture in the computer business was a disaster. AT&T’s strategy needed to change because its operating
environment had changed drastically, thus, i
ts new strategy had to respond to the new opportunities and
threats. AT&T’s old strategy became obsolete due to the dramatic changes in its environment. This does not
imply that its pre
-
1995 strategic vision was seriously flawed.

4
.

Was the strategic rationale for acquiring TCI and Media One sound? If so, why did AT&T reverse course
and sell off its cable assets in 2002? How might AT&T have handled this whole episode differently?

AT&T’s decision to sell their cable assets cam
e about because revenues from broadband did not grow as
fast as anticipated, due to low consumer demand. Also, AT&T may have been unwilling to make the capital
investment necessary to fully implement their strategy. When expenses appeared to be high and re
venues
low, the company was put under pressure from investors to raise short
-
term profits, and thus decided to sell.
Many observers felt that the original strategy was sound, and the decision to sell was a long
-
term strategic
mistake.

As an update, althoug
h AT&T agreed to sell its broadband services to Comcast, in February 2002, the firm
began a move to instead merge its broadband unit with Comcast, with two
-
thirds of the voting stock in the
new firm to be controlled by AT&T. It seems that AT&T reconsidered

its decision and decided not to sell
assets that might potentially be valuable.