Corporate Level Strategy,

Continued...

Horizontal Diversification

Horizontal Scope asks “In which

business areas should we be active?”

Horizontal Scope
Business Area #1 Business Area #2 Business Area #3

Parts Activity
Activity #1
#1 Activity #1

Manufacturing Activity #2
Activity #2 Activity #2

Distribution Activity #3 Activity

Activity #3
#3

Retail Activity #4 Activity #4

Another way to think about “Business Area” = Firm owns/operates these steps in the value chain
is to think of each as a different “Product”

Examples of Horizontal Integration

(Diversification)

Lightbulbs Shipping Questrom

Financing Paper Law School
Jet Engines Steel Medicine
Medical Tech. Insurance Engineering
Oil & Gas Autos A&S
Which Businesses Should You Be In?
HQ (CHQ)

a3
a1+x1 a2+x2 a3 +x3

Assume:
• 1-3 = different divisions (e.g., GE: lightbulbs, jet engines,
healthcare (e.g., MRI Machines)
• a = value created if stand-alone businesses
• x = additional value created from operating businesses
within one firm (note that x may = 0 or be negative in value)
• C = cost (e.g., organizational, bureaucratic costs)

Which Businesses Should You Be In?

HQ (CHQ)

a3
a1+x1 a2+x2 a3 +x3

Key point: In order to have a corporate

advantage, the value gained from combining the
businesses must outweigh the organizational costs

∑ xi > C HQ

Where do efficiencies come from?

Economies of Scale

Economies of Scope
 Economies of Scale
Average Cost Curve
$/Unit $/Unit

AC AC

Quantity Quantity
MC ↓ Minimum
AC ↓ Efficient
Scale

Sources of Economies of Scale

• Spreading fixed-costs over greater volume of

output
• Fixed costs arise from “Indivisibilities”
• Indivisibilities means that an input cannot be
scaled down below a minimum size even when
output is small

Example 1: Aluminum Can Mfg.

Suppose one line: 500 M
(0.5% of US market)
FC/Can at full capacity = $.01

Suppose line is underutilized:

FC/Can at 1/4 capacity = $.04
Production Process:
• Alum. sheet cut to size
• Formed and punched
• Trimmed, decorated
• Lid and tab attached
Single line costs $5 M
Example 2: Web-Based Grocery Stores

• Truck
• Driver
• Fuel

Chicago - Highland Park

Indivisibilities more likely when

production is capital intensive
• Capital Intensive: Costs of productive capital such
as factories and assembly lines represent a
significant % of total costs
• Much productive capital exhibits indivisibility, thus
economies of scale
• As long as there is excess capacity, output can be
expanded at little expense

Contrast with labor or materials: Usually divisible

(change in rough proportion to changes in output,
thus AC does not vary much with output)

Labor expenses can sometimes be

treated as fixed, however
• Substantial fixed travel costs for a
pharmaceutical rep to visit
physicians in a given market area

• Drug makers can reduce average

selling costs whenever sales reps
can promote more drugs per visit

• A large percentage of the costs of

video games is associated with
development and testing

• Average cost per game falls as

total sales increase
 Diseconomies of Scale
If there are economies of scale, then why
don’t we just have one large “megafirm?”
Labor Costs:
• Larger firms generally pay higher wages than do small
firms
‣ More likely to be unionized
‣ “Compensating differential:” wage premium that
firms would need to pay to lure workers to less
attractive jobs
Caveats:
- Worker turnover is usually lower at larger firms
- May be more attractive to highly qualified workers
looking to move up the corporate ladder

Diseconomies of Scale
Spreading specialized resources too thin
• Sometimes successful individuals believe that having
achieved success in one venue they can duplicate it
elsewhere
“I alone can
fix• it!”
Restaurants
• TV Shows
• Cookbooks
Gordon Ramsay
Master Chef

Diseconomies of Scale

Bureaucracy
• “Red tape” and other barriers to getting things done
• Incentives within firms can be muted
• Information flow can be slow
• Departments fighting for scarce corporate resources
can work at cross-purposes
 Economies of Scope
Economies of scope exist if the firm achieves
savings as it increases the variety of goods or
services it produces:

TC(Cx,Cy) < TC(Cx,0) + TC(0,Cy)

“Leveraging core competencies” or “competing
on capabilities” is essentially exploiting scope
economies

Ikea’s skills in product

design extends to a wide
variety of home furnishings

Example
Suppose:
Specialized Firm 1: C(5,0) = 150; C(10,0) = 320
Specialized Firm 2: C(0,50) = 100; C(0,100) = 210
Merged Firm: (C5,50) = 240; C(10,100) = 500
Does this production technology exhibit
economies of scope? Economies of scale?
Economies of scale:
C(5,0) = 150; C(10,0) = 320. Doubling output from 5
to 10 more than doubles cost, so no
Economies of scope:
C(5,50) = 240 < C(5,0) + C(0,50). Producing 5 of x
and 10 of y in merged firm < 150 + 100, so yes

Other Reasons for Diversification

Dominant General Management Logic
• Spreading firm’s underutilized organizational
resources to new area, particularly, managerial talent

C.K. Prahalad Richard Bettis

 Other Reasons for Diversification
Internal Capital Markets
• Allocation of working capital within the firm, as
opposed to raising capital via debt and equity
markets
• Can work when a cash-rich division is under the same
corporate umbrella as a cash-constrained business
operate under the same corporate umbrella
• Thus the diversified firm can create value in a way
that a specialized firm cannot, provided that the
diversification allows the firm to make profitable
investments that would otherwise not be made

Reasons to be Skeptical
Diversifying Shareholder’s Portfolios
• More easily done with lower cost by purchasing
diversified mutual funds
Identifying Undervalued Firms
• Requires that the market valuation of the target
firm is incorrect and that no other investors have
identified this fact

• Merger announcements often induce others to bid,

raising cost, likelihood of winner’s curse

• Loss of Value Post-Merger/Acquisition

THE JOURNAL OF FINANCE • VOL. LX, NO. 2 • APRIL 2005

Wealth Destruction on a Massive Scale?

A Study of Acquiring-Firm Returns
in the Recent Merger Wave

SARA B. MOELLER, FREDERIK P. SCHLINGEMANN,

and RENÉ M. STULZ∗

ABSTRACT
Acquiring-firm shareholders lost 12 cents around acquisition announcements per
dollar spent on acquisitions for a total loss of $240 billion from 1998 through 2001,
whereas they lost $7 billion in all of the 1980s, or 1.6 cents per dollar spent. The 1998
to 2001 aggregate dollar loss of acquiring-firm shareholders is so large because of a
small number of acquisitions with negative synergy gains by firms with extremely
high valuations. Without these acquisitions, the wealth of acquiring-firm sharehold-
ers would have increased. Firms that make these acquisitions with large dollar losses
perform poorly afterward.

IN THIS PAPER, WE EXAMINE THE EXPERIENCE of acquiring-firm shareholders in the

recent merger wave and compare it to their experience in the merger wave of
the 1980s. Such an investigation is important because the recent merger wave
is the largest by far in American history. It is associated with higher stock
valuations, greater use of equity as a form of payment for transactions, and
more takeover defenses in place than the merger wave of the 1980s.1 Though
these differences suggest poorer returns for acquiring-firm shareholders, there
are also several reasons why the acquiring-firm shareholders may have better
Horizontal Scope – Two Tests
returns. With the growth of options as a form of managerial compensation in
the 1990s, managerial wealth is more closely tied to stock prices, presumably
The Better-Off Test
making management more conscious of the impact of acquisitions on the stock
• Satisfied if Efficiency Gains…
∗ Moeller is at the Babcock Graduate School of Management, Wake Forest University; Schlinge-
C(Y ,Y ) < C(Y ,0) + C(0,Y )
mann is at the1Katz2 Graduate School
1 of Business, University
2 of Pittsburgh; and Stulz is at the Max
i.e., average costs ↓ if activities in same firm
M. Fisher College of Business, The Ohio State University, and the National Bureau of Economic
Research. René Stulz is grateful for the hospitality of the Kellogg Graduate School of Management
at Northwestern University and the George G. Stigler Center for the Study of the Economy and
• Or Increased Willingness to Pay
State at the University of Chicago where some of the work on this paper was performed. We are
especially grateful to Harry DeAngelo, Linda DeAngelo, and David Hirshleifer for comments and
discussions. We thank Asli Arikan, Rick Green, Jean Helwege, Michael Jensen, Andrew Karolyi,
Henri Servaes, Andrei Shleifer, Mike Smith, Todd Pulvino, Ralph Walkling, seminar participants
WTP(Y ,Y ) > WTP(Y ,0) + WTP(0,Y )
at the University of Kansas,
1 2 Northwestern University,
1 Ohio State University,
2 and the NBER, and
two anonymous referees for comments. Mehmet Yalin provided excellent research assistance.
1 i.e., average WTP ↑ if activities in same firm
Comment and Schwert (1995) show that 87% of exchange-listed firms are covered by poison pill
rights issues, control share laws, and business combination laws in the early 1990s. They conclude
• Informally known as ‘synergies’
that “poison pills and control share laws are reliably associated with higher takeover premiums”
(p. 3).

757
The Ownership Test
• Must we own it to get benefits?
• What are the alternatives?
• Can contracts work?
• No one-size fits all formula
• Must explain reasons thoughtfully
Example 1:
Better Off Test
Costs (↓):
• Economies of Scope
• Infrastructure already exists to support bottling, distribution, and
marketing
• Costs spread out over more products
• Ordering high volumes of similar ingredients used in Coca-Cola
and Minute Maid concentrates

WTP (↑):
• Promotion and Bundling
• Coca-Cola already has shelf space
• Will expand product line for stores using Coca-Cola products
• Brand Recognition
• Customers are more willing to pay for products that have the
Coca-Cola brand name

Example 1:
Ownership Test
Costs (↓):
• Contracts
• Could contract with other firm to use Coke branding
on other product lines
• But can be expensive and taxing to have to renegotiate
a contract every couple of years
• Hold-up concerns
Other Considerations
• Bargaining Power
• With more variety in its product line Coca-Cola will
have more bargaining power when negotiating contracts
• Can market its brand as having more to offer than its
competitors

Example 2:
Better Off Test
Costs (↓):
• Parts Standardization
• Economies of scale and scope (spread R&D and
marketing costs over more units)
• Software standardization (iTunes, App Store)

WTP (↑):
• Compatibility among products
• Better customer service and support (Genius Bar)
• Enhance learning curve for consumer
Example: Current iPhone users don’t have to learn
how to use an iPad
Example 2:

Ownership Test
Costs (↓):
• Would lose some economies of scope in a contract
• With a contract to distribute an Android phone or Sony
MP3 player, Apple would not be able to spread some
centralized costs (like R&D) over those units
Other Considerations
• Avoid potential holdup from renegotiating contracts every
few years (e.g., if Apple were to distribute Android phones)

Merger Challenges
#1 #2

+
• Unwieldy“It’s
Corporate Structure
a dream deal… (2 Presidents)
creat[ing] the greatest
• Forced move from Boston to Cincy led the
consumer products company in world.”
to exits
• Cultural clashes
• Competing salesforces

Merger Challenges

In September 2005, Ebay acquired

Skype for $2.6 billion
(Skype’s estimated 2004 revenues = $7M)
In acquisition, Ebay stressed “synergies” ––
communication at the heart of the commercial
transactions that make up its primary business:
“eBay is ‘absolutely not’ interested in developing a portal.
You can be sure we’re going to focus on e-commerce.”
 Merger Challenges

Key Points

• The test of a corporate strategy must be

that the businesses in the portfolio are
worth more than they would be under
any other ownership

• Ultimately, diversification can only be

worthwhile if corporate management
adds value in some way

Key Points
Sources of economic efficiency
include:
Economies of Scale
• Arise due to “indivisibilities” and fixed
costs
• Most likely in capital intensive production
• Economies of Scope
• “Leveraging capabilities and resources”
 Key Points
The more related the diversification,
the more likely that value will be
added:
• Similar technologies (same R&D lab,
different uses)
• Similar distribution channels
• Similar customer needs
• Similar “managerial logic” or expertise

Potential Benefits of Diversification

Exploit economies of scope using:
• Tangible resources (e.g., distribution networks
and IT systems)
• Intangible resources (e.g., brand and reputation)
• Organizational capabilities
(e.g., general managerial skills across business
units)
Develop market power
Exploit information advantages
(internal capital or labor markets)

Potential Risks of Diversification

Not always in shareholder’s interest

• Building an empire or maximizing long-term
profit?
• Future profits eroded by acquisition premium?
Diseconomies of scope
• Strategically different businesses?
• Erosion of relative advantage v/v specialized firms
Cultural differences, integration costs