Corporate Strategy: Leveraging Resources to Extend Advantage pot

CHAPTER OUTLINE CASE 1 Exxon Corporation CASE 2 Kao Corporation of Japan CASE 3 AT&T: Shifting Corporate Strategies in the 1990s Introduction The Concept of Resources in Corporate Strate

CHAPTER OUTLINE

CASE 1 Exxon Corporation

CASE 2 Kao Corporation of Japan

CASE 3 AT&T: Shifting Corporate

Strategies in the 1990s Introduction

The Concept of Resources in Corporate

Strategy Alternate Routes of Corporate Strategy

New Stages New Products and Industries

Broad Types of Corporate Strategies

Vertical Integration Related Diversification Building Synergy in Related Diversification Unrelated Diversification

Corporate Strategies Compared

More Attractive Terrain

Growth Profitability Stability

Access to Resources

Physical Assets Technologies Expertise

Sharing Activities

Costs of Diversification

Cost of Ignorance Cost of Neglect Cost of Cooperation

Maximizing Benefits, Minimizing Costs

Achieving Powerful Diversification Benefits Limiting Diversification Costs

Alternatives to Diversification:

Corporate Restructurings

Selective Focus Divestitures and Spin-offs

Corporate Application to Exxon, Kao,

and AT&T Summary

Exercises and Discussion Questions

Corporate Strategy: Leveraging Resources to Extend Advantage

WHAT YOU WILL LEARN

• The concept of corporate strategy

• The notion of a “resource-basedview” of corporate strategy

• How effective corporate strategy can

be used to extend and leverage afirm’s distinctive competence

• The broad types of corporatestrategy, including verticalintegration, related diversification,and unrelated diversification

• Economic forces that motivate thepursuit of different corporate strategies

• How to balance the benefits andcosts of diversification

• Benefits of sharing and leveragingresources among businesses oractivities

• Costs accompanying diversificationand the limitations of sharing

• Why companies undertake corporaterestructuring

• How spin-offs and divestituresrepresent a form of restructuringdesigned to regain focus

As the world’s largest petroleum refiner, Exxon Corporation

currently has numerous oil-producing properties and interests

around the world Throughout the 1980s and 1990s, it has

con-sistently rivaled General Motors and Ford for one of the top

three positions on the Fortune 500 list of companies for sales.

The company has a long history, starting in 1911 after the

breakup of the Standard Oil Company In its early years, it

oper-ated solely as an oil refiner, buying raw petroleum from

pro-ducers in Western Pennsylvania and selling refined products to

dealers in major cities However, the company has subsequently

expanded its operation well beyond this initial base, entering

new stages and segments of the oil industry, offering new

prod-ucts, and moving into entirely new industries It is this

expan-sion that interests us here.

Industry Segments

Oil refining separates petroleum into various components,

including lubricants, kerosene, gasoline, aviation fuel, motor

oils, naphtha, asphalt, and feedstocks for use in the chemical

and plastics industries Many items we use daily are produced

from plastics and chemical composites based on petroleum.

Refining crude petroleum into various products occurs through

a long series of processes Petroleum molecules are reorganized

to form new compounds These compounds are used by

differ-ent customers for their individual purposes The oil industry

thus consists of a number of distinct segments, each defined by

a refining stage and the product’s use Exxon was active in

sev-eral segments such as heating oil, kerosene, naphtha, and

lubri-cants right from its start Over the years it has entered into

spe-cial blend fuels, chemical feedstocks for plastics (e.g.,

ethylene), and industrial solvents, among others It has also

expanded geographically into more than 50 countries around

the globe Currently, Exxon is investing heavily in Latin

Amer-ica, with marketing agreements in Argentina, Brazil, Mexico,

and Venezuela.

Production Stages

The oil industry consists of five stages: (1)

exploration—locat-ing oil beneath the earth’s surface, (2) production—brexploration—locat-ingexploration—locat-ing oil

to the surface, (3) transportation—carrying oil to refiners,

(4) refining—separating oil into its various components, and

(5) marketing—selling refined products to users Although

Standard Oil (Exxon’s early predecessor) began operating at

just one of these stages—refining—it eventually became active

in all five Exxon is therefore a fully integrated oil company

today Fully integrated means that Exxon has committed

sub-stantial investments to all five activities that directly relate to convert petroleum from the ground into higher value-added products.

Product Breadth

Exxon has increased the range of products it offers traditional customers During the 1980s and 1990s, it has begun supply- ing electric utilities with coal and uranium in addition to oil Mining has become important to Exxon to protect its per- formance from wild oil price swings Exxon’s mining opera- tions extend its technical expertise in developing new resources The potential to use shale oil for petroleum, for example, demands expertise in geology The frequent coexis- tence of natural gas with oil means that Exxon must be pre- pared to position itself in the liquefied natural gas (LNG) market as well Many experts predict surging demand for cleaner natural gas fuels as new environmental regulations and alternative applications surface Exxon’s continuous invest- ment in alternative forms of energy, such as LNG, shale oil, and renewable resources (wind and solar technologies) enables it to acquire new forms of knowledge and expertise from different but related energy sectors.

New Industry Positions

Several of Exxon’s diversification moves have carried the company into entirely new industries Its ventures into copper, gold, and zinc mining are examples of this form of natural resource-based diversification Resource mining allows Exxon to use its existing geology and extraction skills to enter these mineral and ore markets On the other hand, Exxon’s

1979 acquisition of Reliance Electric Company, a major ufacturer of electric motors, involves diversification into an entirely new and different industry The manufacture of elec- tric motors has only indirect benefits to helping Exxon improve its operations and financial performance, since another set of skills and capabilities are needed Exxon also entered the office automation and equipment market during the 1970s and 1980s, but subsequently retreated because it lost money Its most memorable product from its foray into the office automation industry was the Qyx typewriter that attempted to compete with IBM’s Selectric-brand typewriters The Qyx was an innovative machine at the time; it utilized a free-moving, ribbon cartridge that allowed for smoother and more fine-grained office printing.

Kao Corporation is Japan’s largest producer of soaps,

deter-gents, dishwashing liquids, personal care and health products,

and other consumer goods In many ways, it is Japan’s

counter-part and answer to Procter and Gamble and is organized along

similar lines Its 1997 revenues topped $7.26 billion, and its net

income was over $220 million, making it one of the world’s

largest consumer nondurable and personal care products firms

in the world Kao is known throughout Japan and Asia and

offers more than 600 different products with numerous brands.

The company is also developing a strong position in other

industries and technologies, such as (1) fats, oils, emulsifying

agents, and thin-film coatings for use in its core lotions, health

care, and personal care products, (2) specialty chemicals and

polymer resins for use in the printing, plastics, and textile

industries, and even (3) floppy disks and thermal paper for the

personal computer industry Kao is expanding its presence in

the United States and Europe by operating R&D centers in

these locations.

Product Categories and Breadth

Competitive advantage in consumer nondurable products, such

as shampoos, detergents, and soaps, depends upon a company’s

ability to customize them to local markets, while offering a new

array of products continually New product development and

strong marketing capabilities (especially in distribution and

market research) represent critical skills needed to compete in

markets that often exhibit a high volatility and change Global

competitors such as Procter and Gamble, Colgate-Palmolive,

Unilever, Henkel, and Kao, must develop and test new product

concepts and ideas in rapid-fire succession Many of these

products are R&D and advertising-intensive Considerable

expertise in applied chemistry, blending, distribution, and

mar-keting research is needed to design, develop, and produce new

products for fast-changing markets Thus, consumer

non-durables encompass a broad range of products that require

fre-quent market testing Market research and testing are vital tasks

for companies such as Kao, since competitors can imitate their

products quickly.

Kao spends heavily on R&D each year (up to 5 percent of

sales per year) to develop advanced chemistry-driven

tech-nologies and skills concerning surfactants, emulsifiers,

coat-ings, adhesives, fatty acids, alcohols, and oils Surfactants, for

example, are used in detergents, dishwashing liquids, and

cleaners, where they interact with water to remove grease and

other oily substances Emulsifiers are an important component

of many personal, health care, and convenience products, since they help to keep oils and other substances in the proper level of balance and suspension with other ingredients Kao’s expertise with surfactants and emulsifiers has also allowed the company to learn and invest in thin-film coatings technolo- gies In the broadest sense, thin-film coatings are used in many consumer and commercial applications, in which chem- icals and other substrates are carefully applied (in extremely thin layers) to a given surface area to achieve some desired effect For example, thin-film coatings are at the heart of new nicotine-suppressing drugs that are delivered through skin (epidermal) patches to help customers avoid cigarette use The skin patch has an extremely thin layer of a drug that is deliv- ered steadily over time through the skin Fatty acids, alcohols, and oils are used not only as ingredients for many personal care products but also as end products in their own right for the food processing and other chemical-based industries Each year, Kao introduces a new range of products based on these skills and ingredients This strategy of rapid product develop- ment, combined with investment in core chemistry and mar- keting skills, enables Kao to keep its competitors off balance, especially in its close Asian-based markets Kao’s wide assort- ment of products and excellent marketing research capabili- ties also give the company significant market power with wholesalers and retailers.

Extending Advantage Through New Skills

Kao’s renowned strength in chemical and product-based vation can be seen in numerous hit products that have reached Asian and U.S markets For example, in the early 1990s, Kao pioneered a reduced-fat cooking oil This oil also can be used

inno-in salad dressinno-ings, bakinno-ing, and stir-fryinno-ing inno-in half the amount needed with conventional oils—an important marketing factor for many increasingly health-conscious markets During the late 1980s, Kao beat back a major challenge by Procter and Gamble in the Japanese disposable diaper market Using its superior knowledge of the Japanese market, Kao was able to counter many of P&G’s inroads with its own version of the popular, disposable Pampers diapers In a broader sense, many

of Kao’s products closely follow and resemble those of ica’s Procter and Gamble and Europe’s Unilever Both P&G and Unilever consider Kao a formidable competitor in its tech-

Amer-nological and marketing prowess Many of Kao’s highly

suc-cessful product innovations have come from its ultra-modern and impressive R&D facilities In fact, concentrated laundry

detergents (powder and liquid) were discovered through

aggressive research and marketing-based competition between

Kao’s and Procter and Gamble’s research laboratories in Japan.

The superconcentrated liquid Tide detergent that is found on

the store shelves of many U.S grocery and convenience stores,

for example, resulted from the intense research efforts put forth

by P&G to improve its product line relative to Kao and other

domestic competitors in Japan.

In summer 1997, Kao introduced a new product in the

United States known as Biore Pore Perfect Designed as a skin

care and cleansing product, Biore is a patch-like product that

customers apply to the nose, face, and other areas that attract a

high concentration of hard-to-clean oils and residues Kao is

believed to have captured some $55 million in sales in the last

half of 1997 from sales of this new hit product Despite the

high price of the product ($6.00 per box), some pharmacy

chains were already running out of the product Biore is an

extremely popular product because it enables customers to

attain that ultra-clean feeling of clean pores in the skin that

conventional means of washing cannot readily achieve.

Although Biore currently represents a small (but rapidly

grow-ing) portion of Kao’s consumer-oriented business, it is a telling

demonstration of how Kao has been able to combine its

knowl-edge of thin-film coatings with its formidable market research

capabilities to create an entirely new product category Biore’s

cleansing patch (similar to the skin patches now used to

trans-mit nicotine-suppressing drugs) is the byproduct of Kao’s

investment in the area of thin-film coatings that are now used

in very innovative ways The chemicals layered along the

Biore patch product include softening agents that are used in

hair conditioners and shampoos as well.

Kao competes with P&G and other domestic competitors

in Japan’s and Asia’s complex distribution channels With

respect to innovating and managing its marketing and

distri-bution channels, Kao utilizes strategies, techniques, and new

programs similar to America’s Wal-Mart All products are

extensively bar-coded Inventories are monitored daily

through a centralized information system and distribution

facility This system keeps track of sales and spot pricing

trends from data gathered at wholesalers and retailers with

lit-tle time delay or lag between recorded sales and new orders

entered into the system Thus, Kao is closely tied in with its

largest buyers in much the same way that Wal-Mart works

with its major suppliers This tight management and control of

supply chain and distribution channels enables Kao to “pull”

products through its wholesalers and retailers while

minimiz-ing inventory and holdminimiz-ing costs To continue its domestic and

global growth, Kao produces many of its products in local

markets It has quickly secured important market positions

throughout Asia.

New Market Entry

Throughout the 1980s, Kao expanded deeply not only into Asia but also into Europe and the United States It acquired several chemical companies in Europe Kao also set up a German sub- sidiary, Guhl Ikebana, that distributes shampoos throughout Europe Kao’s research facility in Paris is the center for its fra- grance development A large R&D center in Darmstadt, Ger- many, forms the nexus of European operations in skin care and beauty product development In the United States, it has an ongoing joint venture with Colgate-Palmolive In 1988, Kao acquired the Andrew Jergens company, a company once best known for producing a smooth hand lotion This move further accelerated Kao’s presence in the North American market The Andrew Jergens Research Center in Ohio has become an impor- tant center of Kao’s expertise in lotion-based products A key function of both European and U.S R&D facilities is to modify proprietary Kao ingredients to create products for local mar- kets Across Asia, Kao’s manufacturing and distribution facili- ties proliferate throughout Thailand, Indonesia, Hong Kong, Singapore, Taiwan, and more recently, China.

New Businesses and Industries

Kao defines its core skills and competences along the broad

strategic concept of surface action science Surface action

sci-ence refers to the use of applied chemicals and even thin films

to coat an open surface area Kao uses this guiding concept as a tool to consider which new businesses to enter Some of Kao’s most important skills are in applied chemistry and coatings Expertise with thin films, fatty acids, lotions, oils, alcohols, and other chemicals forms the basis of Kao’s products Most con- sumers do not think of these chemicals as the building blocks of soaps, shampoos, detergents, and such radically new products

as the Biore skin-cleaning patch Yet, they provide the basis for expansion into other industries that use a similar set of applied chemistry, coatings, and blending skills Kao’s specialty chem- icals and surface agents divisions supply polymers, lubricating oils, and additives to firms in the plastics, ink, and computer industries These industries represent an alternative application

of surface action science In the mid-1980s, Kao expanded its strategy of surface action science to include the development and manufacture of floppy disks for personal computers Since that time, Kao’s floppy disk operations have accounted for a fast-growing share of the data storage market To further extend its expertise, Kao acquired High Point Chemical Corporation of the United States in 1987 High Point produces textile chemi- cals, fiber lubricants, de-inking agents, and agricultural chemi- cals In the 1990s, Kao has begun to apply the thin-film layer- ing skills learned from floppy disks to make ink ribbons, thermal paper, and digital audio tape Most of these products are supplied to other companies under their brand name.

During the 1990s, AT&T Corporation, America’s leading

telecommunications services firm, has undergone a series of

major strategic shifts in its corporate strategy Within a span of

eight years, the company has moved from being a fully

inte-grated provider of computers, communications equipment,

semiconductors, consumer electronics, telephone services, and

even financial services to a much more streamlined

telecom-munications firm At the beginning of the decade, AT&T’s

for-midable R&D, manufacturing, and marketing capabilities gave

it the resources and scope to compete against the likes of such

huge competitors as Toshiba and NEC of Japan, IBM and

Motorola of the United States, and Ericsson, Siemens, and

Alcatel of Europe AT&T’s enormous investments in a broad

range of technologies enabled it to design, develop, and apply

such leading-edge applications as video transmission, virtual

reality, advanced voice recognition software, ultra-fast

semi-conductors, multimedia standards, and new forms of wireless

transmission None of these technologies were commercially

viable as recently as six years ago, but they are now widely used

and expected in state-of-the-art telecommunications, Internet,

and computer-networking equipment Yet, in 1998, the current

AT&T Corporation (1997 revenues of $53.2 billion, net income

of $4.64 billion) bears little, if any, resemblance to the company

that came close to becoming a major player in a variety of

dif-ferent industries at the start of the 1990s It is this shift in

cor-porate focus and realignment that interests us here.

Early 1990s: Multiple, Integrated Businesses

Since the deregulation of the long-distance telephone business

in 1983, the nature of the telephone business has evolved to

become more of a telecommunications business In the

broad-est sense, existing telephone lines (primarily copper) and new

technologies (fiber-optic cable, packet switching, and wireless)

once used primarily for transmitting voice signals can now be

used to relay voice, video, and data signals in ways that greatly

expand the flexibility and versatility of communications The

ability to transmit a number of different signals (voice, video,

data) speedily and simultaneously along a network requires a

tremendous increase in bandwidth In its purest sense,

band-width is the difference between the highest and lowest

frequen-cies of a transmission signal More broadly, increases in

band-width refer to the number of different frequencies that a

particular transmission media can provide In popular parlance,

an increase in bandwidth refers to an increase in the capacity of

a given transmission medium to process voice, video, or data

flows, often measured by how many bits per second can be transmitted or carried With the rise of new ways to communi- cate across multiple mediums (wireline—copper, coax cable, and fiber optics; wireless—airwaves via radio frequencies; and Internet—data packets of any signal created through digitiza- tion), AT&T during the early 1990s invested large sums into becoming an important provider of voice, wireless, and data transmission equipment and services.

AT&T’s entry into new technologies and products during the early 1990s emanated from a dual strategy of selected acquisitions and internal development efforts focused around a series of key technologies Acquisition of other firms started aggressively in 1990 with AT&T’s buyout of computer giant NCR This move gave the company access to a well-established mainframe computer business, as well as a big overseas pres- ence AT&T envisioned that mainframe computers were a vital pillar to helping the firm develop new telecommunications serv- ices that were based on the merging of computers with com- munications In 1993, AT&T initiated the purchase of two important businesses, Go Corporation and McCaw Cellular Communications Go Corporation was a leading designer of personal hand-held computers that are the basis for today’s per- sonal digital assistants (PDAs) In 1994, Go Corporation was completely integrated into AT&T’s Microelectronics unit The acquisition of McCaw Cellular enabled AT&T to develop more fully its national wireless network The McCaw Cellular buy- out, followed later by the purchase of major stakes in Lin Broadcasting, further strengthened AT&T’s position in rolling out a more extensive cellular phone system coverage in key metropolitan areas More important, entrance into the wireless segment enabled AT&T to compete indirectly with the local phone companies in providing cellular phone coverage These acquisitions complemented the internally generated skills and technologies that originated from Bell Laboratories.

A corporate resource vital to AT&T’s efforts to develop new technologies internally in the early 1990s was its world-renowned Bell Laboratories unit Bell Labs remains one of America’s lead- ing research laboratories and holds numerous patents in many sci- entific and research areas involving high-energy physics, advanced electronics, mathematics, new materials, lasers, and computer programs and software Bell Labs provided much of AT&T’s knowledge and talent that eventually made their way into new technologies and products sold by AT&T In addition, AT&T (through its Western Electric unit) manufactured many vital elec- tronic components that have direct application to other related

communication areas such as semiconductors, fiber optics,

multi-plexing devices, computer-networking equipment, and advanced

imaging technologies These breakthroughs paved the way for

more advanced forms of communications, networks, and even

video game applications Thus, by 1995, AT&T provided both the

hardware and software used in many high-technology

applica-tions for a number of different industries.

By the mid-1990s, some of AT&T’s cutting-edge

technolo-gies included the Hobbit microprocessor, which could compute

13 million instructions per second by using significantly less

power than comparable Intel-made 486-based chips AT&T

Microelectronics, the developer of the Hobbit, has also designed

video-compression technologies and chips that make it possible

to transmit live video images over telephone lines and, later,

through wireless techniques and platforms This same

Micro-electronics unit has helped Hewlett-Packard shrink a

conven-tional computer hard-disk drive to the size of a credit card Using

its proprietary and cutting-edge technologies, AT&T entered the

consumer electronics industry For example, through its

acquisi-tion of Go Corporaacquisi-tion, AT&T pioneered one of the first

pen-based, hand-held personal computer known as Eo, a technology

that was the precursor to many of today’s personal digital

assis-tants (PDAs) such as the PalmTop Smaller and more efficient

semiconductors and power supply devices from AT&T

Micro-electronics are also making their way into new computers,

cel-lular phones, and workstations—even in those devices

manufac-tured by some of AT&T’s rivals With its full range of R&D,

technological capabilities, and manufacturing-based skills,

AT&T thus became a major player in communications,

comput-ers, semiconductors, and electronics by the mid-1990s.

Mid-1990s: A Renewed Telecommunications

Focus for AT&T

By late 1995, however, AT&T’s senior management believed

that the firm’s fully integrated and broad-based entry into

com-puters, communications, semiconductors, consumer

electron-ics, and telecommunications had become too cumbersome to

manage In September 1995, CEO Robert Allen expressed his

concern that despite the company’s legendary development and

implementation of many new technological breakthroughs,

AT&T was increasingly at a disadvantage when it competed

against more focused, nimbler, and agile competitors in the

long-distance telephone and other telecommunications

busi-nesses CEO Allen believed that a number of environmental

factors were beginning to complicate AT&T’s highly complex

strategy to compete across a number of different businesses.

First, companies such as MCI Communications (now MCI

WorldCom), Sprint, and other new entrants were steadily eating

away into AT&T’s share of the long-distance business (market

share fell from 70 percent to 60 percent in six years) The

long-distance business generated a large amount of cash from ing operations, which was often diverted into other businesses (e.g., Microelectronics) or to fund large acquisitions of other companies (NCR, McCaw Cellular) Also, a big portion of this cash was used to fund cutting-edge R&D and products that often generated comparatively small returns on investment or languished in the laboratory Over time, AT&T’s core long- distance business began to atrophy while other competitors were making steady inroads into its market with deep discounts and aggressive marketing promotions.

exist-Second, the Microelectronics and Western Electric businesses were unable to attain their full financial, technological, and sales potential within the AT&T umbrella, largely because these units faced significant obstacles to selling their state-of-the-art tech- nologies, products, and networks to other telecommunications and network customers Firms in the long-distance (e.g., MCI, Sprint), local telephone (e.g., Ameritech, SBC Communications, Bell Atlantic, U.S West), and wireless businesses (e.g., Sprint PCS) were increasingly reluctant to invest in new types of net- working and communications equipment made by AT&T Micro- electronics and Western Electric because they felt that their pur- chases would inevitably strengthen an already major competitor that demonstrated strong ambitions to enter new markets In the meantime, AT&T’s competitors in the networking equipment industry such as Alcatel, Ericsson, Motorola, Northern Telecom (Nortel Networks), Fujitsu, and Siemens had begun cementing important sales agreements with the large Regional Bell Operat- ing Companies (RBOCs) for leading-edge equipment Moreover, managers at both Microelectronics and Western Electric felt an internal obligation to always satisfy their internal customer first (AT&T long-distance), rather than to aggressively pursue other telecommunications customers Thus, the difficulties in coordi- nating activities between AT&T’s long-distance business’ needs with that of Microelectronics’ and Western Electric’s needs slowed down the entire company.

Finally, AT&T’s widely cherished belief that convergence between mainframe computers and communications to create

an entirely new telecommunications platform never quite rialized The acquisition of NCR in 1990 to build a “third wave”

mate-of advanced communications capabilities failed to produce value and competitive advantage when innovative computer- networking technologies rapidly displaced mainframe comput- ers as the key pillar to support the integration of voice, video, and data Instead, cutting-edge technologies such as advanced data hubs, switches, and routers are now the backbone of today’s Internet New competitors such as Cisco Systems, Ascend Communications, 3Com Corporation, Fore Systems, Tellabs, and other networking firms have done much to design, develop, and build the equipment that is the backbone of today’s Internet and telecommunications network.

Thus far, most of our examination of competitive advantage has been from the

stand-point of a firm operating a single business within an industry We are now ready to

broaden our view A firm can develop new capabilities by expanding into other

seg-ments, businesses, or industries Such expansion is guided by corporate strategy The

Thus, in September 1995, AT&T broke itself into three

dif-ferent companies by divesting the networking equipment and

mainframe computer business The original AT&T Corporation

would concentrate on its core long-distance and emerging

telecommunications and Internet-driven businesses AT&T

Microelectronics, Bell Laboratories, and the Western Electric

manufacturing unit became an independent, new firm known as

Lucent Technologies Lucent’s share offerings were made to the

public in April 1996 The mainframe computer business

returned to its previous independence and namesake as NCR.

Late 1990s: New Growth and Challenges

As of June 1999, all three companies, AT&T, Lucent

Tech-nologies, and NCR are much more focused entities In

partic-ular, Lucent Technologies has become a leading developer and

provider of state-of-the-art telecommunications, photonics,

computer-networking, and semiconductor (digital signal

processors) technologies At the end of 1997, Lucent

Tech-nologies’ revenues were close to $26.5 billion with net income

of $541 million As of April 1999, however, Lucent boasted a

market capitalization that topped $140 billion, even greater

than that of its former parent AT&T ($130 billion), and has

become one of the most potent competitors in the telecom and

computer-networking equipment businesses Most important,

Lucent Technologies has aggressively moved away from many

low-margin businesses to focus on data-networking products

(hubs, switches, and routers) that compete directly with

pow-erhouse Cisco Systems to build the infrastructure for the

Inter-net It has also won a series of important sales contracts from

local telephone companies (e.g., SBC Communications) that

would have been reluctant to purchase equipment from it as

recently as three years ago The new firm is also a major player

in the semiconductor industry Lucent now produces advanced

digital signal processors (DSPs) that are at the heart of

advanced digital cellular phones and other consumer

electron-ics applications After many early successes, Lucent is now in

the curious position of deciding whether to continue its own

strategy of internally developing new technologies through its

Bell Labs unit or to acquire other smaller companies to quickly

build market share and gain access to new technologies So far,

in the thirty-six months that it earned its independence, Lucent

has also acquired a number of extremely innovative ing companies, such as Prominet, Livingston, Yurie, Triple C Communications, Ascend Communications, and Lannet The original AT&T, now focused on its core long-distance and growing Internet businesses, has become more active in pursuing new acquisitions to penetrate the local telephone business Since the Telecommunications Act of 1996, long-distance companies are now free to enter the local telephone business and vice versa (with government approval on a case-by-case basis) In January

network-1998, AT&T purchased Teleport Communications Group, a local telephone company in the Northeast, for $11.3 billion from Com- cast Corp., Tele-Communications, Inc., and Cox Enterprises— three cable television companies that once had aspirations to enter the local phone business themselves However, the cable compa- nies underestimated the amount of investment in new technology that was required to convert one-way cable lines into two-way communication systems Teleport is an important acquisition for AT&T because it has over 250,000 direct communication lines to business customers that bypass the expensive Regional Bell oper- ating networks With the Regional Bell companies potentially moving closer into the long-distance business, AT&T’s acquisi- tion of Teleport could be viewed as a first-mover strategy to fore- stall the local telephone companies’ future moves In late June

1998, AT&T purchased Tele-Communications Inc (also known as TCI) for $37.3 billion The complicated deal enables AT&T to pursue faster entry into the local phone business and to put the Internet into every home that has cable, but there are numerous technical obstacles to implementing this strategy Most important, converting cable’s one-way television lines into two-way conduits will cost additional billions Also, local phone companies are competing with an alternative set of technologies (Digital Sub- scriber Line) that use existing copper lines to provide Internet access as well By way of its TCI acquisition, AT&T also gains access to new Internet cable access technology through TCI’s AtHome affiliate AT&T is now in the midst of looking for other acquisition candidates in the cable television and Internet arenas.

On the other hand, NCR, the former giant in mainframe computers, has continued to languish as the industry faces ongoing challenges from personal computers, computer net- working systems, and single-digit growth In 1997, NCR’s rev- enues were $6.58 billion with net income of $7 million.

issues surrounding corporate strategy are different and significantly more complex thanthose for a firm operating a single business in one industry Corporate strategy requiresmanagers to establish a coherent, well-defined direction that guides the allocation of

resources into new areas of activity Corporate strategy in this book refers to the

iden-tification of opportunities and the allocation of resources to develop and extend thefirm’s competitive advantage to other activities or lines of businesses In its most pow-erful application, corporate strategy is more than the sum of the firm’s individual busi-ness unit strategies; it seeks to leverage the firm’s distinctive competence from one busi-ness to new areas of activity

Corporate strategy is an important but often misunderstood area of management An

overwhelming number of the Fortune 500 companies operate more than one line of ness In fact, recent research shows that the average Fortune 500 company has positioned

busi-itself in about ten different businesses Such expansion, however, is not easy One mark study found that more than half of all acquisitions made by 33 large corporationsprior to 1975 were subsequently divested by 1985.4Moreover, many of the large Fortune

land-500 companies that have attempted to enter new lines of businesses (General Electric,

IBM, General Mills, Sears, American Express, and AT&T) have encountered serious ficulties in building and extending their competitive strengths even to businesses andindustries that they knew well The key issue of corporate expansion into new activities or

dif-businesses may be viewed as follows: Is a firm’s competitive advantage in one business or

area of activity strengthened by the firm’s presence in another? Identifying activities or

businesses that satisfy this requirement is the focus in this chapter

First, we examine the concept of what resources are important to formulating a ent corporate strategy Ideally, well-formulated corporate strategies are based on utilizingand leveraging resources that enable the firm to create distinctive sources of value andadvantage over a long time period Managers need to build their corporate strategies onthose resources—assets, skills, and capabilities—that are hard for other firms to duplicate.Second, we consider the various routes to expanding the number of businesses a firm oper-ates Third, we look at specific types of corporate strategies that enable firms to leveragetheir resources and skills to extend their competitive advantage to new areas of activity Wefocus our attention on the issue of diversification in particular Fourth, we then considerthe chief benefits and costs associated with each type of expansion, especially as it con-cerns diversification Finally, we offer guidelines to help firms achieve the benefits ofexpansion into new areas while avoiding its costs

coher-THE CONCEPT OF RESOURCES IN CORPORATE STRATEGY

Corporate success in extending sources of competitive advantage to new ucts, businesses, and market segments—depends heavily on how well firms have devel-oped and cultivated those assets, skills, technologies, and capabilities to create a set of dis-tinctive competences and resources that are significantly different from those of itscompetitors In many ways, the central issue that relates to building competitive advantage

arenas—prod-at the business-unit level—leveraging a distinctive competence to crearenas—prod-ate a competitiveadvantage—is fundamentally no different an issue than that for companies trying to com-pete across multiple businesses However, managing a diverse set of multiple businessunits, particularly those involving market positions among different industries, signifi-cantly adds to the complexity of operations

Building and leveraging sources of competitive advantage among multiple businessunits within a diversified firm thus calls for a different perspective that recognizes theinherent complexity of managing assets, skills, technologies, and capabilities across the

corporate strategy: plans

and actions that firms need

to formulate and implement

when managing a portfolio

of businesses; an especially

critical issue when firms

seek to diversify from their

initial activities or

operations into new areas.

Corporate strategy issues

are key to extending the

firm’s competitive

advantage from one

business to another.

firm’s different subunits When considering the issue of corporate strategy, firms need to

understand how their broader collection of resources contributes not only to leveraging

their distinctive competences among internal businesses, but also to competing against

other firms as well In many ways, successful corporate strategy is based on identifying

those resources that enable a firm to build systemwide advantage among its businesses in

ways that other firms cannot readily imitate or duplicate During the 1990s, this

resource-based view of the firm is becoming more important to understanding corporate strategy.5

From this perspective, corporate strategy will be successful only to the extent that the firm

possesses and leverages those resources (assets, skills, technologies, capabilities) that

share a number of important characteristics

First, a firm’s resources should ideally be so distinctive that they are hard for

competi-tors to imitate or duplicate The more distinctive or hard-to-imitate the resource, the less

likely there will be direct competition in that arena If a resource (skill, technology, or

capability) is hard to imitate, then any future profit stream and competitive advantage is

likely to be more enduring and sustainable Conversely, those resources that are

easy-to-imitate will generate only temporary value, since other firms can readily copy that skill

Over the long term, however, few corporate resources will sustain their hard-to-imitate

qualities unless firms continue to invest and upgrade them at a rate faster than what other

competitors can do As we noted in Chapter 4, it is difficult for the vast majority of firms

in the semiconductor industry to sustain their distinctive resources and skills over a long

period of time when new entrants and competitors come out with ever newer designs,

man-ufacturing processes, and advanced materials as the product goes through its life cycle

stages On the other hand, an organizational capability for fast innovation such as that

found at Hewlett-Packard or Procter and Gamble may be considered a valuable resource

that is hard-to-imitate

Second, a firm’s resources should also be highly specialized and durable This feature can

often represent a double-edged sword Highly specialized assets and skills can produce

long-lasting value, but they can also be very rigid and hard to change when new technologies or

demand patterns arise Some of the most specialized and durable assets can also limit a firm’s

ability to respond to environmental changes, as we have seen in the Eastman Kodak and

Timex examples On the other hand, some of the best examples of where highly specialized

and durable resources have created sustainable advantage over long time periods include

such assets as brand names and patents Brand names such as Walt Disney, Procter and

Gam-ble, AT&T, IBM, Frito Lay, American Express, Intel, and Microsoft provide these firms with

a durable, lasting degree of staying power and freedom to maneuver, even when their

respec-tive markets may be fast-moving Patents, especially those in the pharmaceutical and

chem-ical industries, are another way in which specialized and durable resources can be readily

used and reused to build and leverage new sources of competitive advantage Both brand

names and patents may be significant resources in helping firms formulate and implement

their corporate strategies, since they are enduring over an extended period of time

Third, firms need to monitor the environment so that their corporate resources do not

suffer from easy substitution from other competitive providers of similar value-adding

activities In other words, even when a firm’s set of resources is hard-to-imitate and highly

durable, senior managers need to remain aware of potential substitute threats from firms in

other industries who may bring to bear an entirely different set of assets, skills,

technolo-gies, and capabilities to the current industry or arena Over the long term, however,

emerg-ing products, services, or technologies that could serve as substitutes are likely to surface

in any industry Yet, many firms have invested in learning new sets of skills and

capabili-ties that enable them not only to deal effectively with the emerging substitute threat but

also to embrace the substitute as part of its own redefined strategy For example, until

resource-based view of the firm: an evolving set of

strategic management ideas that place considerable emphasis on the firm’s ability to distinguish itself from its rivals by means of investing in hard-to-imitate and specific resources (e.g., technologies, skills, capabilities, assets, and management approaches).

1994, Microsoft had not really developed a well-thought-out strategy for dealing with suchpioneering upstarts as Netscape Communications and others who were riding the firstwave of the Internet By late 1995, realizing the potential threat that Netscape’s Web-browser products could eventually substitute for many of its existing stand-alone, desk topapplications, Microsoft completely shifted its strategy and made the Internet a central part

of its corporate strategy to extend its software design and applications skills to learning andbuilding new businesses

Using many of these resource-based perspectives, we now begin to examine how firmscan develop various types of corporate strategies for leveraging their sources of competi-tive advantage into new arenas

ALTERNATE ROUTES OF CORPORATE STRATEGY

Firms usually begin their existence serving just one or a few niches At some point duringtheir evolution, many expand beyond their initial base or core business.6Such expansionincreases the diversity of customers a firm serves, the number of products it produces, andthe technologies it must learn and manage This pattern is therefore broadly referred to as

expanding the scope of operations Scope of operations refers to the extent of a firm’s

operations across different activities, products, and markets Corporate strategy is cerned with selecting the products, markets, and industries in which to extend the firm’sdistinctive competence

con-Expansion into other activity areas is considered successful when the firm’s distinctivecompetence is strengthened by moving into new areas.7 Recall that a firm’s distinctive

competence refers to what it can do particularly well vis-a-vis its competitors Distinctive

competence is rooted in such attributes as a central technology, resource, expertise, or skillthat the firm uses to create and add value From the perspective of corporate strategy, if afirm can successfully apply and extend its distinctive competence to new activities, prod-ucts, or markets, then it can develop competitive advantage across multiple businesses Themost common routes to enlarging the firm’s scope of operations are expansion into newstages of the industry value chain and expansion into new products and industries (seeExhibit 6-1)

New Stages

Firms may expand their scope of operations to include different stages or levels of adding activity within the same industry Expansion into an earlier or later stage of a firm’s

value-base industry is usually referred to as vertical integration We briefly discussed vertical

integration in previous chapters as a source of competitive advantage for a single-businessfirm Yet, vertical integration is also a corporate strategy issue, since it involves enlargingthe scope of what the firm does to include other value chain activities It can take two basic

forms: backward integration and forward integration Backward integration moves the firm into an activity currently carried out by a supplier Forward integration moves the

e x h i b i t (6-1) Common Avenues to Enlarging the Firm’s Scope of Operations

scope of operations: the

extent of a firm’s

involvement in different

activities, products, and

markets.

vertical integration: the

expansion of the firm’s

value chain to include

activities performed by

suppliers and buyers; the

degree of control that a firm

exerts over the supply of its

inputs and the purchase of

its outputs Vertical

integration strategies and

decisions enlarge the scope

of the firm’s activities in

one industry.

backward integration: a

strategy that moves the firm

upstream into an activity

strategy that moves the firm

downstream into an activity

currently performed by a

buyer (see vertical

integration, backward

integration).

firm closer to its customers.8 Standard Oil (Exxon) integrated backward when it moved

into oil production from its initial base in refining It integrated forward when it began

retailing gasoline through its own service stations

AT&T in the early 1990s became steadily more vertically integrated in the computer

and communications industries Semiconductors (chips), lasers, digital coding schemes,

and fiber optics represent key capabilities required to build long-distance switches and

net-works, hand-held computers, and transmission hardware They represented the building

blocks AT&T thought were necessary to make its own equipment without relying on

exter-nal suppliers Thus, expansion into these high-tech areas represented backward integration

for AT&T On the other hand, managing cellular phone networks allowed AT&T to get

closer to its customers by offering services without an intermediary or middleman This

move is forward integration

New Products and Industries

Backward and forward integration do not take a firm beyond its initial industry

Diversifi-cation does, however DiversifiDiversifi-cation involves entry into fields where both products and

markets are significantly different than those of a firm’s initial base.9There are two basic

types of diversification: (1) related and (2) unrelated.10 Related diversification occurs

when a firm expands into industries similar to its initial business in terms of at least one

major function (manufacturing, marketing, engineering) or type of skill used (e.g.,

micro-electronics, packaging, surface coatings, thin-film technologies, or display screens)

Related diversification is thus concerned with extending the firm’s distinctive competence

to other lines of business

Unrelated diversification is expansion into fields that do not share any functional or

skill-based interrelationship with a firm’s initial business Unrelated diversification

there-fore involves entry into new industries that share no distinctive competence with the firm’s

initial business

To illustrate related diversification, consider Exxon’s expansion into copper mining

Copper and oil are different products used by different customers, so this diversification

represents industry diversification The two businesses utilize similar operating

technol-ogy (extraction of a raw material from beneath the earth’s surface), similar skills in

geol-ogy (for exploration and testing), similar logistics (bulk transportation), and similar

mar-keting (selling a commodity product) These characteristics thus make this move related

diversification Kao’s diversification into cooking oils, shampoos, and detergents also

represents related diversification, since these products all require applied chemistry skills

The technologies for these products are based on Kao’s expertise with lotions, oils,

alco-hols, and other chemical agents As such, Kao produces new types of consumer personal

care products by developing various applied chemical compounds to achieve the right

mixture AT&T’s entry into consumer electronics and multimedia represents related

diversification, since these businesses drew upon AT&T’s existing skills in

miniaturiza-tion and semiconductors For example, AT&T’s introducminiaturiza-tion of the Eo personal hand-held

computer in 1992 was based on the company’s strength in microelectronics, which is also

used in its computer-based switching equipment All of these products are related

Exxon’s acquisition of Reliance Electric, by contrast, represents unrelated

diversifica-tion Reliance’s major product—an electric motor—is unlike oil, Exxon’s major product

Customers for the two products are also different The value chain configuration required to

manage these businesses—engineering, procurement, logistics, operations, distribution, and

marketing—are entirely different The acquisition of Reliance Electric represents unrelated

diversification for Exxon since Reliance has little relationship to Exxon’s core products

diversification: a strategy

that takes the firm into new industries and markets (see related diversification, unrelated diversification).

related diversification: a

strategy that expands the firm’s operations into similar industries and markets; extends the firm’s distinctive competence to other lines of business that are similar to the firm’s initial base (see related industry, unrelated diversification).

unrelated diversification:

a strategy that expands the firm’s operations into industries and markets that are not similar or related to the firm’s initial base; does not involve sharing the firm’s distinctive competence across different lines of business (see related diversification, related industry).

BROAD TYPES OF CORPORATE STRATEGIES

These three expansion routes lead to three broad types of corporate strategies In this tion, we examine in detail these three types of corporate strategies: (1) vertical integration,(2) related diversification, and (3) unrelated diversification These strategies provide verydifferent opportunities to extend distinctive competence Each of these three corporatestrategies is based on a specific economic motive as it relates to enlarging the firm’s scope

sec-of operations Each sec-of these corporate strategies has different implications for the way thatcompanies can extend their distinctive competence into new areas of activity

Vertical Integration

Vertical integration allows the firm to enlarge its scope of operations within the same all industry Vertical integration is characterized by the firm’s expansion into other parts ofthe industry value chain directly related to the design, production, distribution, and/or mar-keting of the firm’s existing set of products or services Many companies practice verticalintegration in some way Companies engage in vertical integration primarily to strengthentheir hold on resources deemed critical to their competitive advantage Vertical integration

over-is an important strategy for firms that face great uncertainty, especially as it concerns theirsources of supply or future buyers of their products Moreover, vertical integration enablesthe firm to reduce the external transaction costs of working with numerous suppliers and

customers Recall from Chapter 4 that transaction costs are those costs involved in

find-ing, buyfind-ing, sellfind-ing, negotiatfind-ing, and overseeing activities with other firms in the openmarket Lower transaction costs are especially important for firms when high economicuncertainties make external long-term contracts costly.11

Full vs Partial Integration. Firms can vertically integrate in varying degrees Some

firms may attempt full integration Full integration occurs when the firm seeks to control

all stages of the value chain related to the final end product or service In the automobileindustry, a potential example of full integration would be Ford Motor Company’s owningeverything from the coal mines used to make steel; the steel mills that make body panels,doors, engines, and car frames; to the glass used in windshields; all the way to the dealer-ships that finance and sell cars to customers In Case One of this chapter, Exxon practicesfull integration It owns and controls all activities related to the exploration, production,refining, and distribution of petroleum products

On the other hand, firms can also attempt a limited form of vertical integration known

as partial integration Partial integration refers to a selective choice of those value-adding

stages that are brought in-house For example, Ford Motor Company could achieve partialintegration by owning the engine and assembly plants necessary for making cars, but sell-ing off the coal plants and steel mills to other firms that may be more efficient than Ford

in managing those operations Firms exhibit some degree of partial integration when theyattempt to control strategically important or valuable activities but rely on externalproviders or outsourcing for activities that do not match their competitive strengths

Backward Integration. The direction of vertical integration may be as important as itsdegree Backward integration can allow firms to convert a previously external supplier into

an internal profit center Consider AT&T’s strategy in the early 1990s By amassing its ownin-house chip development capability, AT&T lessened its reliance on external suppliers of

a component vital to manufacturing its higher value products, such as the phones,switches, and other devices that incorporate these chips When AT&T previously bought

full integration: vertical

integration that seeks to

control every activity in the

value chain In full

integration, firms bring all

activities required to

design, develop, produce,

and market a product

in-house (see partial

integration).

partial integration:

vertical integration that is

selective about which areas

of activity the firm will

choose to undertake In

partial integration, firms do

not control every activity

required to design, develop,

produce, and market a

product (see full

integration).

chips and other electronic devices from outside firms, it was dependent on these suppliers.

However, its Microelectronics unit’s capability to produce the chips and other electronic

devices in-house enabled AT&T not only to reduce the uncertainty of future supply but

also to learn and to extend chip-based technologies to new products

The need for supply certainty helps explain Exxon’s steady integration into petroleum

production throughout the company’s history Producers in the 1920s were beginning to

integrate forward into refining If many did so, Exxon’s refining business might someday

be deprived access to raw petroleum supplies in desired quantities at attractive prices By

integrating backward into oil production, Exxon effectively removed this threat

Backward integration is particularly common in industries where low cost and certainty

of supply are vital to maintaining the firm’s competitive advantage in its end markets For

example, drug companies often exhibit high levels of backward integration to ensure

sup-ply of necessary chemical ingredients for their pharmaceuticals On the other hand, firms

competing in industries defined by rapid product and technological change are likely to

avoid extensive backward integration, fearing that the high fixed capital costs associated

with backward integration will reduce the flexibility needed to respond to rapid change

Forward Integration. Forward integration is designed to help the firm capture more of

the value added in the product or service offered to the customer For example, when

American Express sells travelers checks and other financial services through its travel

agencies, it is seeking to capture those customers who might otherwise buy their travelers’

checks and insurance from banks and other firms Similarly, when General Motors, Ford,

and Chrysler bought large stakes in nationwide car-rental firms such as Hertz, National,

Budget, Dollar, and Thrifty, they sought to achieve forward integration The Big Three

wanted to capture some of the profits not only from the rental agencies’ purchase of their

cars, but also from the customers who rent those cars on an intermittent basis

A desire to forward integrate into lower-cost medical delivery and prescription services

motivated pharmaceutical giant Merck to purchase distribution powerhouse Medco

Contain-ment Services Merck is one of the world’s leading developers and producers of brand-name

proprietary drugs During the late 1980s, more and more customers and physicians began to

use off-brand generic drugs that often were lower-priced than Merck’s products Many of

these generic drugs were sold through large, competing drug wholesalers, such as

McKesson, Cardinal Health, Bergen Brunswick, PCS, and Medco Unlike Merck, these

firms do not develop or patent drugs on their own but primarily acquire their products from

other leading drug companies In response, Merck decided that it could not afford to allow

its drug prices to be severely undercut In 1993, Merck’s decision to acquire Medco, one of

the largest drug wholesalers in the United States, enabled Merck to distribute its own drugs

more cheaply because of Medco’s vast distribution network to physicians, retailers, and

phar-macies Through this move, Merck can retain customers interested in buying drugs through

discount channels In a similar move, pharmaceutical competitor Eli Lilly in 1994 made its

own acquisition of PCS, another leading drug distribution system Lilly believed that

own-ership of PCS would enable it to negotiate better pricing terms with other large retailers and

managed care firms that wanted to take steps to limit annual price increases of new drugs.12

Thus, vertical integration strategies extend the firm’s scope of operations to other

activ-ities within the same industry Basically, all vertical integration strategies are motivated to

some extent by (1) accessing vital resources, both backward toward suppliers and forward

toward customers, (2) extending the firm’s control over critical value-adding activities

directly concerned with its core products or services, (3) reducing uncertainty of relying

on external suppliers or buyers, (4) ensuring a more stable or efficient flow of value-adding

activities within its own operations and key processes, and (5) capturing profits that might

otherwise leave the firm The cumulative potential benefit of vertical integration strategies

is that they tend to reduce the economic uncertainties and transaction costs facing the firm,

at least in the short term

Vertical integration strategies are not without their disadvantages, however They cansometimes lead a firm to overcommit scarce resources to a given technology, productionprocess, or other activity that could then lock the firm into eventual obsolescence In addi-tion, excessive vertical integration may also weigh down the firm with significantly highfixed costs, leaving it vulnerable to an industry downturn Vertical integration can also poseproblems of meshing different capabilities and skill sets For example, Eli Lilly did not real-ize that managing extensive drug distribution channels through its PCS acquisition wouldrequire a very different set of skills as compared to pharmaceutical R&D and marketing ThePCS unit eventually became a drag on Lilly’s financial performance in 1995 and 1996.13

Likewise, vertical integration can also pose problems of balancing capacity andthroughput in the firm’s operations These disadvantages are particularly amplified forthose firms attempting full integration For example, if Ford Motor Company shouldattempt to own its own set of coal mines, steel mills, and assembly plants and dealerships

to a much greater degree than rival DaimlerChrysler, then an economic recession wouldhave much more devastating effects on Ford than it would on DaimlerChrysler Ford’shigher level of fixed costs threaten to keep Ford in the red longer than DaimlerChrysler,which would not be as burdened with excess capacity and other problems For Exxon,however, the benefits of full integration significantly exceed the disadvantages Exxonneeds to control all stages of petroleum production, since any significant disruption in sup-ply or distribution would send shock effects throughout the entire company

Related Diversification

Related diversification is perhaps the most important corporate strategy discussed in thischapter for a number of reasons First, related diversification is an increasingly common

corporate strategy found in large companies worldwide Many Fortune 500 firms are

pur-suing some variant of related diversification, and interest in this strategy is growing inEurope and the Far East

Second, related diversification is directly concerned with extending the firm’s tive competence or set of firm-specific resources into new lines of business and industry,

distinc-as opposed to limiting the firm’s scope of operations to within the same industry Recallthat a firm’s distinctive competence is a central technology, resource, or skill that it uses todesign, develop, produce, or market its products Related diversification offers firms thepotential to extend and leverage their distinctive competences/resources into new indus-tries that share common characteristics Third, related diversification poses a highly com-plex set of issues for managers, since the resources and skills used to guide related diver-

sification strategies are often the key to obtaining corporate synergy Synergy exists when

the whole of the company is greater than the sum of its parts In other words, related sification creates value not only in the firm’s individual businesses, but across the entirefirm as well For these reasons, related diversification represents perhaps the single mostimportant trend defining current corporate strategy today

diver-Focus on Synergy. Related diversification is an extremely attractive and potent strategythat aims to extend the firm’s distinctive competence (technologies, resources, and skills)

to areas of activity in other lines of businesses or industries The primary economicmotive for related diversification is that firms can create new sources of value by extend-ing and applying their distinctive competence across a wide array of similar businesses

synergy: an economic

effect in which the different

parts of the company

contribute a unique source

of heightened value to the

firm when managed as a

single, unified entity.

and activities Related diversification works to extend a firm’s distinctive competence by

building a corporate-level, firm-specific, resource-based source of competitive

advan-tage Corporate-level advantage occurs when value is created both in a firm’s individual

business units, and system-wide across a firm’s businesses Thus, the goal of related

diversification is to achieve synergy This objective is realized when the value of the

whole firm is greater than the discrete value of its individual business units

Focus on Internal Development. Firms can attempt related diversification through

var-ious channels For example, firms could (1) identify and exploit an underlying technology

or skill that defines the way a product is designed or manufactured, (2) start up new

prod-ucts or services where key value-adding activities can be shared across a wider base,

(3) develop and commercialize new products that borrow from the firm’s brand name

recognition, manufacturing prowess, or R&D capability, or (4) acquire new businesses that

closely match and complement the firm’s existing strengths or distinctive competence in

its original activity Note that the most common steps to achieve synergy are through

inter-nal development as opposed to acquiring other firms or businesses Interinter-nal development

seeks to share or transfer the firm’s resources and skills to other business units

Numerous examples of related diversification can be found in every industry Our

ear-lier illustrations of Exxon’s investments in copper and uranium mining, Kao’s

develop-ment of new cooking oils, soaps, shampoos, and health care products, and AT&T’s

inter-nal development of semiconductors and fiber optics all represent forms of related

diversification The electronics industry is full of examples of related diversification

Sharp Corporation of Japan pursues related diversification when it develops and

pro-duces a broad line of calculators, desktop copiers, television sets, and video camcorders

Sharp’s set of distinctive resources includes its highly specialized competence in

preci-sion manufacturing skills, expertise with liquid-crystal display (LCD) technology,

flat-panel technology, miniaturization, and an organizational capability for fast product

development All of Sharp’s product groups share a common need and access to these

distinctive resources By extending its manufacturing skills from calculators to

cam-corders, Sharp expands its manufacturing base and experience to new products In turn,

Sharp creates value by being able to lower its manufacturing costs even further by

spreading them over a wider base of products Sharp’s products are not only similar in

using related LCD and flat-panel display components, but they also lend themselves well

to similar marketing by way of mass distribution channels, such as Best Buy, Circuit

City, and other electronic superstores

Hewlett-Packard also pursues a related diversification strategy It produces electronic

measuring instruments for hospitals, testing firms, and laboratories, along with

calcula-tors, personal computers, laser printers, software, supercomputers, and new multimedia

and Internet technologies for the broader consumer market Hewlett-Packard’s

distinc-tive competence/ resource is its capability to undertake rapid development and fast

inno-vation of cutting-edge products This distinctive competence allows H-P to develop

internally and build a rapid succession of winning products for a variety of end markets

By producing high-quality calculators, Hewlett-Packard further refines its product

development skills and expertise used to design electronic measuring instruments and

controllers for laser printers Having a strong market presence in consumer electronics

and office equipment helps reinforce Hewlett-Packard’s position in building its

Internet-oriented businesses and vice versa Overtime, however, if the Internet-Internet-oriented

busi-nesses begin moving faster that H-P’s traditional measurement busibusi-nesses, then it may

become more difficult for H-P to remain competitive and distinctive in each business

with the same degree of staying power

Building Synergy in Related Diversification

Central to related diversification is the notion of building mutually reinforcing, closely

fit-ting business units The task of related diversification is to identify and leverage the firm’s

distinctive competence and resources (assets, technology, capabilities, skills) acrossclosely fitting businesses to create new sources of value that form the basis for buildingsynergy Strategic fit occurs when the value chains of different business units are similarenough to create a corporatewide basis for competitive advantage

Identifying Fit. The first step in building synergy is identifying the potential for close fitamong the firm’s different businesses For example, in the case of Sharp, the precision manu-facturing skills and display technologies used in making televisions, VCRs, and notebook com-puters also apply to office equipment (e.g., copiers) In the case of AT&T, MCI WorldCom,Sprint, and other telecommunications firms, future service offerings are becoming more related

to their core network management, Internet, electronic commerce, and data-transmission andnetworking businesses Motorola has brilliantly succeeded in leveraging its distinctive compe-tence in semiconductor manufacturing and development to compete in the fast-paced cellulartelephone, communications, and paging equipment businesses Motorola has been able totransfer its proprietary manufacturing skills and techniques from one line of business to another,resulting in fast product development and low-cost, high-quality products

Finding a close fit to build synergies is not easy Oftentimes companies will discoverthat their distinctive competences do not lend themselves well to application in otherindustries or markets For example, Marriott Corporation found that its expertise in pro-viding high-quality food in its family-oriented restaurants, cafeterias, and hotels did notgive it much capability to compete in top-of-the-line gourmet restaurants Similarly, Blackand Decker’s excellent reputation for high-quality appliances and tools designed for do-it-yourselfers did not automatically translate into higher sales of power tools aimed at pro-fessional contractors and construction firms AT&T discovered a similar problem in 1995.Skills in R&D and manufacturing (now in Lucent Technologies) did not readily apply tomanaging and operating an advanced telecommunications network that could handle thehuge surge and demand for Internet-based traffic, electronic commerce, and other services.AT&T’s skills in product development did not in any way guarantee a success in under-standing how newer forms of data-networking technologies could redefine the telephoneand Internet backbone business almost overnight Thus, a crucial first step for managersundertaking related diversification is to assess how well the firm’s distinctive competence

lends itself to direct application to other markets or industries The firm’s distinctive

com-petence should be leveraged for competitive advantage across all of its business units.

Making the Competence Hard-to-Imitate and Durable. The second step in buildingsynergy is to make the firm’s distinctive competence and resources (assets, technologies,capabilities, and skills) as distinctive as possible from the competition and enduring over

a long period of time Firms engaging in related diversification need to invest continuously

in their distinctive competence or corporate resources so that they become difficult forcompetitors to imitate and thus preserve the competence’s or resource’s long-term value.The more distinctive the firm’s set of resources (capabilities, skills, and technologies), themore difficult it is for competitors to copy and imitate the firm’s strategy A truly distinc-tive skill or competence will enable the firm to lower costs, enhance differentiation, oraccelerate learning in ways faster or better than its competitors

Related diversification works best when firms can build a competence that is so tinctive and utilized systemwide that it is nearly impossible for competitors to duplicate it.Durable, specialized assets or skills are a key pillar in attaining successful related diversi-

dis-fication In the case of Kao, its proprietary and durable skills in blending and applied

chemistry for new lotions, shampoos, and films are difficult for competitors to imitate but

can easily be applied to new differentiated products such as the Biore skin cleaning

sys-tem In the Sharp and Hewlett-Packard examples, few companies could have easily

mus-tered or quickly copied the precision manufacturing or fast product development skills of

both companies An organizational capability for fast innovation or quality manufacturing

is hard-to-imitate and constitutes specialized and durable resources that last over many

product generations and life cycles Firms with very distinctive competences are well

posi-tioned to create potentially new sources of value and competitive advantage across their

businesses that will be difficult for competitors to imitate and copy

Managerial Fit. Finally, a strong fit among the different managers that run the

underly-ing businesses is important Managers with similar levels of entrepreneurial qualities,

tech-nical knowledge, marketing savvy, or engineering backgrounds provide an important

foun-dation for building synergies A convergence of managerial mindsets can reduce the

coordination costs among the businesses Transfer or rotation of managers across different

business units can help solidify the firm’s management fit The more closely fitting and

related the various business units are, the more important a tight managerial fit becomes

This fit helps management understand both the characteristics of individual businesses and

the overarching distinctive competence of the firm Value creation at both business and

corporate levels becomes easier when managers work jointly to develop ways to extend the

firm’s distinctive competence across businesses

Thus, related diversification strategies are designed to extend the firm’s distinctive

com-petence and corporate resources to other products, businesses, and industries Related

diversification aims to create synergy, whereby the firm leverages its distinctive

compe-tence to achieve a mutually reinforcing, tight fit among its businesses When pursued

suc-cessfully, related diversification enables the firm (1) to lower its costs across a wider base

of activities, (2) to increase or heighten the differentiation of its businesses, and (3) to

accelerate learning and transfer of new technologies, skills, or other capabilities at a rate

faster than if the business units remained separate

Unrelated Diversification

Although the majority of Fortune 500 firms are now emphasizing related diversification,

many firms during earlier periods engaged in a corporate strategy of unrelated

diversifica-tion Unrelated diversification occurs when a firm seeks to enter new industries without

relying on a distinctive competence to link up business units These firms were popularly

known as conglomerates Conglomerates are firms that practice unrelated diversification.

Unlike related diversification, unrelated diversification is not based on any distinctive

competence or central set of hard-to-imitate corporate resources Consider, for example,

the case of Allegheny-Teledyne, a large conglomerate Allegheny-Teledyne has extensive

defense electronics businesses, financial services, stainless steel (through its

Allegheny-Ludlum acquisition in 1996) industrial products, consumer goods (Water Pik toothbrushes,

for example), and machinery The company does not attempt to share an underlying

tech-nology or skill among these various businesses

During the 1970s, the list of unrelated diversified firms or conglomerates was long

and included such names as Teledyne, Textron, Litton Industries, Gulf and Western (now

part of Paramount Communications), American Can (now Primerica, which has recently

merged with financial services firm Citigroup), and ITT Although many of these firms

are still found in the Fortune 500 listings, their proportional representation of large U.S.

companies has declined significantly in the past fifteen years.14Unrelated diversification,

conglomerates: firms that

practice unrelated diversification (see unrelated diversification, holding company structure).

or conglomerate-based strategies, became popular during the 1960s and 1970s nies such as Textron, ITT, Litton Industries, LTV, and others bought companies in suchfar-ranging industries as steel, textiles, typewriters, movie studios, household appliances,and silverware Any conceivable business that appeared to be attractive for future growthwas a candidate for acquisition Conglomerates grew by way of acquiring other compa-nies, instead of developing core skills internally Because unrelated diversification doesnot rely on a distinctive competence, companies are free to purchase existing firms withalready established market positions Some of the methods by which firms pursue unre-lated diversification include (1) buying high-performing companies in an attractiveindustry, (2) buying cash-poor companies that could utilize additional funds for a quickturnaround, (3) buying a company whose seasonal and cyclical sales patterns would pro-vide stability to the firm’s total cash flow and profitability, and (4) buying a largely debt-free company to improve the acquiring firm’s borrowing power Note that these methods

Compa-do not attempt to identify and to extend a distinctive competence from one business unit

to another The primary corporate resource used among these subunits is financial age In addition, the only linkage between newly acquired and preexisting business units

lever-is that of financial ties, as opposed to technological or skill-based resources

Perhaps the two best examples of how unrelated diversification as practiced in the 1990s

is giving way to renewed focus are that of Tenneco and Textron Some of Tenneco’s parate businesses in the early part of the decade included farm and construction equipment(J I Case), natural gas pipelines, shipbuilding (Newport News Shipbuilding), chemicalsand materials (Albright and Wilson), automotive parts, and containers/packaging (Packag-ing Corporation of America) Tenneco acquired these businesses over the past twenty years

dis-in the belief that diversity brought stability of earndis-ings The farm equipment busdis-iness, forexample, operates on a cycle different from the shipbuilding or packaging businesses Dur-ing a recession, for example, farm equipment sales plummet, while automotive parts go up(mostly because people keep their older cars longer) By 1992, Tenneco pushed each busi-ness unit to lower its costs to compete better in its own industry However, this effort hasproved difficult at Tenneco, since quality improvement and cost-reduction efforts in onebusiness are not easily transferred to another In April 1994, Tenneco decided to put 35 per-cent of its J I Case farm equipment subsidiary up for sale to the public Because Case hasrecovered from its early 1990s recession, Tenneco now wants to use the cash from this sale

to improve its overall corporate balance sheet The cash would be used to reduce corporatedebt By late 1995, Tenneco’s packaging subsidiary (the PCA unit) undertook several largeacquisitions of other companies to double its size over the next five years Through 1996and 1997, Tenneco continued to reduce the enormous scope of its diversification breadth.The Newport News Shipbuilding company was sold off in late 1996, and Case has nowbecome fully independent from Tenneco In July 1998, Tenneco announced that it wouldformally separate its remaining automotive and packaging operations Such a move couldultimately signal the division of the firm into two companies Even further, Tenneco willdivide PCA’s packaging business into even more narrowly defined paperboard and specialtymaterials units that will serve its respective market using their own resources.15

Another company that practices unrelated diversification is Textron At the height of itsdiversification posture, some of Textron’s most well-known businesses included businessjets (Cessna), helicopters (Bell Helicopter), golf carts and sporting equipment (E-Z-Go),chain saws (Homelite), lawn mowers (Jacobsen), watch bands (Speidel), disability insur-ance (Paul Revere), consumer finance (Avco), aircraft parts (Accustar), tank and aircraftengines (Lycoming), and industrial fasteners In 1998, Textron sold its Avco insurance andconsumer finance subsidiaries to Associates First Capital, a financial powerhouse that wasrecently part of Ford Motor Company Associates First Capital bought Avco Financial Ser-

vices because it represented a complementary fit to its own commercial and credit-card

financial services businesses Textron’s current corporate strategy is to allocate some $1

billion to buy new businesses, mostly on the industrial side, that are clearly dominant in

their industries.16

Beating the Market. The examples of Tenneco and Textron also point out some of the

problems in pursuing an unrelated diversification strategy For example, Tenneco’s desire

to grow its containers/packaging business by using funds acquired from selling J I Case

is a bet that the packaging subsidiary is likely to be a growing and profitable long-term

business However, senior management cannot always accurately predict how each

indi-vidual business is likely to perform in the future Also, senior management cannot

effec-tively formulate the specific, competitive strategies required for each business and

mar-ket The economic motive of unrelated diversification is that the corporation creates value

to the extent that it is able to identify attractive acquisition or new business opportunities

faster than the market can Trying to even out the business cycle swings across different

industries requires precise resource allocation and timing to ensure that the value

acquired from new businesses justifies their acquisition costs This task is difficult to

accomplish at best

Rise of a Conglomerate Discount. Unrelated diversification strategies assume that

sen-ior management can predict which businesses will do well over time In other words, the

economic rationale for conglomerates is based on the financial market’s acceptance of

sen-ior management’s judgment and selection of acquisition candidates that appear to be

attractive for the future The basic source of value in a conglomerate is senior

manage-ment’s ability to time the market to buy and sell businesses This task generally proves to

be difficult to perform consistently, because senior management cannot stay abreast of

day-to-day operations in each individual business In addition, throughout the 1990s, many

conglomerate firms suffered because of the high debt costs incurred to buy businesses

Several researchers have pointed out the existence of a so-called conglomerate

dis-count, whereby the sum of the individual parts is greater than the value of the whole.17In

fact, poorly managed conglomerate firms appear to provide dysynergy in which individual

businesses may actually be worth more on their own rather than when placed under a larger

corporate umbrella with other unrelated units In other words, unrelated diversification

strategies can actually destroy value instead of creating it Senior management often

can-not lower costs, enhance differentiation, or accelerate learning in the conglomerate’s vast

array of businesses

During the 1990s, however, senior management at many conglomerate firms began to

recognize the strong tendency by the market to discount these firms’ values To counter this

tendency, companies such as Litton Industries, ITT, Allegheny-Teledyne, and Textron have

begun a process of divesting themselves of some of their businesses Moreover, these same

companies are trying to become more focused by limiting their acquisitions to only those

businesses that appear to have some potential for synergies Thus, conglomerates may

become more related over time

Acquisitions over Internal Development. The unrelated diversification strategies of

con-glomerates are designed to acquire, hold, and sell businesses in various industries without the

benefit or guide of an underlying distinctive competence Unrelated, or conglomerate-based,

diversification is based entirely on acquiring and selling different parts of the firm to

max-imize corporate profitability When compared with related diversified firms, unrelated

firms grow and contract primarily through asset acquisitions and divestitures Unrelated

diversification presents little opportunity to grow by developing new businesses internally.Senior management is not focused on identifying and extending a distinctive competencethat can be leveraged across businesses Nevertheless, when pursued successfully, unre-lated diversifiers can maintain a high level of corporate growth and profitability Thebiggest disadvantage of this strategy rests on the assumption that senior management will

be able to beat the market consistently in identifying and purchasing attractive businesses

in other industries

Corporate Strategies Compared

So far, we have examined three different types of corporate strategies: vertical tion, related diversification, and unrelated diversification The basic differences betweenthese three strategies are important enough to reiterate Vertical integration is based onextending the firm’s scope of operations to other value-adding activities within the sameindustry Unlike related or unrelated diversification, vertical integration is concerned pri-marily with improving efficiency and the core operations of the firm’s existing activities

integra-It does not extend the firm’s distinctive competence to activities in other industries orbusinesses

Related and unrelated diversification are two corporate strategies that do extend thefirm’s scope of operations beyond the initial industry Both of these diversification strate-gies move the firm into new areas of activity that represent different competitive condi-tions, products, and markets Related diversification is based on extending the firm’s dis-tinctive competence among closely fitting businesses Firms pursuing this strategy seek touse their existing resources (assets, skills, capabilities, and expertise) as a way to build andextend competitive advantage across different businesses and markets By doing so, theyare hoping to increase the value of the entire firm, thereby generating synergy Unrelateddiversification also takes the firm beyond the initial industry However, it does not require

a distinctive competence to identify and select new areas of activity Acquiring and sellingbusinesses remain the dominant focus of the unrelated diversification strategy

Diversification is directly concerned with extending the firm beyond its original try The next section considers the major benefits that diversification can provide Diversi-fication can provide a firm three different kinds of benefits: (1) more attractive terrain,(2) access to key resources, and (3) opportunity to share activities among businesses (seeExhibit 6-2)

C Sharing of activities

(any business system activity)

MORE ATTRACTIVE TERRAIN

New terrain may be more attractive than that of a firm’s base business for several reasons

(see Exhibit 6-2A)

Growth

New terrain may be growing more rapidly, thus providing opportunity for more rapid

expansion, economies of scale, and learning new skills Entry into high growth areas gives

the firm access to potential new sources of technologies and skills In time, these resources

could become the basis for future industries This search for growth by way of extending

technologies into new products and markets is particularly appropriate for related

diversi-fication strategies

Exxon’s concern about the petroleum industry’s growth contributed to its interest in

diversification As oil prices skyrocketed following the Mid-East turmoil of the 1970s, the

rate of growth in worldwide demand for petroleum declined By diversifying into alternate

fuels and businesses outside the energy field, Exxon was able to sustain its expansion

despite reduced growth in its original industry The same growth logic also applied to

AT&T’s earlier attempts at related diversification Entry into more promising computer

and consumer electronics businesses was believed to counter some of the reduced growth

of the long-distance telephone business In addition, advanced computers and consumer

electronics represented growing businesses that use many of AT&T’s newest

technologi-cal developments in advanced materials, lasers, and software By staking out new positions

in these two growing industries, AT&T sought to define new industry standards for future

products (customized software to operate future computers and electronics hardware, for

example) that could potentially use considerable amounts of AT&T technology

Companies such as IBM, DuPont, Toshiba, and Hitachi are also diversifying their core

operations to search for newer growth opportunities In the case of IBM, the slow growth of

revenues from its core mainframe business mean that IBM must carefully identify and select

new emerging product and market opportunities in which to invest (e.g., semiconductors,

net-working systems, servers, miniaturized disk drives, advanced routers, electronic commerce,

Internet-related businesses) For example, IBM has extended its extremely precise

manufac-turing techniques used for semiconductors to enter such related areas as making ultra-dense

disk drives, compact disc etching equipment, flat-panel display screens, and even advanced

lasers and optics used in telecommunications DuPont, realizing that many of its fiber

busi-nesses are approaching maturity (Nylon, Dacron), is extending its knowledge of synthetic

fibers into the composite materials business (e.g., Kevlar, Tyvek), and most recently, into life

sciences (pharmaceuticals and biotechnology) DuPont is also exiting from its low-growth

upstream petroleum operations by putting its Conoco oil unit on the block for sale.18Japanese

electronics giants Toshiba and Hitachi are seeking to revitalize their growth by diversifying

away from their mature core power generation, memory chip, and mainframe computer

busi-nesses The growth in these businesses has slowed considerably in recent years

Profitability

The desire for higher profitability also leads firms to search for new terrain New terrain

may be less competitive, thereby enabling a firm to earn a higher rate of return Fewer

competitors mean that firms often have “breathing room” to improve their profitability and

to innovate new, related products Consider the following examples The cost of finding

new oil is increasing as more accessible deposits near the earth’s surface are depleted

For-eign competitors possess huge oil reserves that can be tapped at low cost They are in a

position to undercut Exxon and other domestic producers if they choose Fixed costs ofexploration, development, and testing will continue to mount, despite lower likelihood ofhitting oil Breakthroughs in any of these areas may erode oil profits even further over thelonger term By diversifying into new fields, Exxon is better able to preserve its prof-itability in the event these threats materialize.

Despite its wide range of successful consumer products, Kao continues to feel strongcompetitive pressure from Procter and Gamble, Colgate-Palmolive, Unilever, and otherfirms in its traditional consumer health care products Unrelenting pressure to cut costs andinnovate new products has sharply reduced Kao’s profitability in these areas The compet-itive market for floppy disks, however, is less fierce and enables Kao to utilize its superbskills in coatings technology to earn higher rates of return Kao’s entry into the floppy diskmarket thus represents a search for better profitability

AT&T’s concern that MCI WorldCom and Sprint may erode the profitability of its corelong-distance business was an important factor motivating it to enter new areas such asadvanced computers and consumer electronics The long-distance business remainsextremely competitive, despite high levels of government regulation Competitors are free toenter the long-distance business, while AT&T at the time was largely prevented from pro-viding local phone service This means that AT&T was forced to remain on the defensive, atleast in the short-term, in its long-distance business from more aggressive entrants

In another example, Japanese producers of VCRs and television sets are beginning tofeel low-cost pressure from Korean firms (Samsung, Lucky-Goldstar) in their core con-sumer electronics businesses This pressure is prompting firms such as Sharp, Sony,Canon, and Matsushita to develop new technologies that allow them to enter higher profitareas, including office equipment, factory automation, electronic instruments, semicon-ductors, and household appliances (related diversification) Movement into these newareas gives the Japanese firms an opportunity to sidestep some of the fierce competitionthat characterizes the television and VCR industries

Stability

Finally, new terrain may be more stable than a firm’s base business in terms of the cal nature and fluctuations of output Firms sometimes face huge price swings in their corebusiness, which lead to distortions in both production planning and pricing of the firm’sproduct Diversification into businesses with different industry cycles may allow a firm togenerate more predictable levels of sales and profits Entering other businesses to coun-terbalance the core business’ output swings can even out the company’s total revenue andprofit picture By expanding into a field with more stable characteristics, a firm can some-times move away from problems in its core business Unrelated diversification is particu-larly concerned with stability of earnings from different businesses Textron and Tennecohave used this strategy since the mid-1970s

cycli-Political turmoil in the Middle East and erratic behavior by members of OPEC nization of Petroleum Exporting Countries) have caused the world price of oil to fluctuatewidely in recent decades These gyrations have caused major fluctuations in Exxon’s ownearnings Exxon’s expansion into businesses subject to different economic cycles (coal,uranium, and copper) has been motivated in part by a desire to reduce earnings fluctua-tions in the future

(Orga-ACCESS TO RESOURCES

A second common motive for diversification is a desire to secure access to resources Byacquiring a firm that possesses a scarce resource or market position, a firm can significantly

improve its own competitive position Similarly, a firm that possesses a critical resource can

often improve the position of another business by acquiring and transferring the resource to

it Resources frequently acquired and transferred in this way are physical assets,

technolo-gies, and expertise (see Exhibit 6-2B)

Physical Assets

Diversification can be prompted by firms seeking access to the physical assets, such as

manufacturing plants or distribution centers, that complement the firms’ original

busi-nesses Firms will often buy another company because the physical assets utilized by its

previous management were undervalued, or firms will acquire other businesses because of

the scarcity or uniqueness of the assets involved For example, Sony of Japan acquired

U.S entertainment assets during the late 1980s (Columbia Pictures and CBS Records)

Part of the reason for these acquisitions was the Japanese giant’s desire to secure the large

film libraries whose values were likely to grow in the future Films and television shows

made by Columbia Pictures represented important assets because they are becoming

crit-ical pieces of the emerging multimedia and cable television industries The films,

televi-sion shows, and documentaries possessed by movie studios represent the “content” or

“software,” that is likely to flow along the future information highway and interactive

tel-evision sets Matsushita also purchased MCA Universal in the late 1980s but was forced

to retreat from the business in 1995 when the synergies between electronics and

entertain-ment proved illusory

In the past decade, WorldCom has become a major player in the telecommunications

industry by acquiring numerous other smaller firms to gain access to their physical assets

From 1987 to 1997, WorldCom has grown substantially by acquiring such firms as

Metro-media Communications, Resurgens Communications, WilTel Network, and Advanced

Telecommunications to acquire state-of-the-art fiber optic networks that were laid out by

these and other firms In 1996, WorldCom acquired MFS Communications to secure that

firm’s enormous Internet “backbone” that is now becoming the basis for the nation’s data

transmission network Through its UUNet subsidiary, MFS Communications allows

WorldCom to layer its own physical telecommunications network with that of the Internet

in major cities Acquiring all of these firms enabled WorldCom to amass an enormous

amount of telecommunications assets and skills in a short time Moreover, it strengthened

WorldCom’s market position and power by enabling it to consolidate a number of smaller

firms into a larger entity In September 1998, WorldCom merged with MCI

Communica-tions to become MCI WorldCom, the nation’s leading Internet “backbone” company and

second largest long-distance company

Technologies

Technological advances provide the underlying basis for innovating and commercializing

new products Developments in new technologies, such as robotics, display screens,

microelectronics, software, genetic engineering, and advanced composite materials,

repre-sent the building blocks of future industries Diversification is an important way for firms

to learn, to extend, or to acquire new technological resources that could have serious future

impact on their businesses, especially for firms practicing related diversification

Many industries are becoming more related because of the sheer intensity and use of

technology involved For example, United Technologies, a leading provider of jet engines

(Pratt and Whitney), elevators (Otis), helicopters (Sikorsky), building systems (Carrier),

and microelectronics, is facing a growing technological convergence among its businesses

All of these individual businesses are becoming more related because of the growing

degree that microelectronics, hydraulics, and control systems play in making UTC’s ucts function The control technology used to develop avionics and aircraft cockpits is sim-ilar to those in the air-conditioning, heating, lighting, and security systems found in manymodern office buildings Thus, technology developed in one core business can often beleveraged and extended to other fields far beyond the original industry.

prod-Diversification can help firms improve the operating posture of their core businesses.For example, in 1987, Rockwell International, a major defense contractor, purchasedAllen-Bradley, a leading developer of flexible automation technologies Rockwell believedits numerous defense electronics, communications, microwave, automotive, and aerospacebusinesses would eventually face not only greater cost-containment pressures but alsohigher quality requirements in the future The acquisition of Allen-Bradley gives Rockwell

a new source of manufacturing technology that enabled it to revitalize its existing coreindustrial and high-technology businesses

Cisco Systems is another example of a firm that has obtained needed resources throughdiversification Ever since the firm went public in 1990, Cisco Systems has strengthened itsleading technological and market position in providing network equipment solutions to firms

in the telecommunications and Internet-related industries In the past five years alone, Ciscohas made over twenty acquisitions of firms that possess a proprietary technology or capabil-ity in the field of bridges, hubs, routers, and software management tools that allow data to betransmitted throughout the world along fiber-optic, Internet networks Some of Cisco’s mostimportant acquisitions include Grand Junction Networks (September 1995), StrataCom, Inc.(April 1996), Granite Systems (September 1996), LightSpeed International (December1997), NetSpeed (March 1998), Fibex Systems, Sentient Networks, and GeoTel (all in April1999) All of these firms have developed critical computer networking technologies thatenable Cisco to blend its offerings with those of the acquired firms to provide customers with

a full array of technologies and advanced products Cisco’s growth strategy has been so cessful that it passed the $100 billion capitalization mark in July 1998.19One share of Ciscostock in June 1990 is worth 144 shares at the time of this writing

suc-Expertise

Expertise possessed by a business in the form of information, knowledge, or skill hasalready been paid for It therefore represents an essentially free good and invaluableresource to another business that can utilize it If two such businesses merge, expertisepossessed by one can be transferred to the other, producing potentially important eco-nomic benefits, especially if the expertise is highly specialized, durable, and hard-to-imitate This extension of knowledge and expertise between companies forms a vitalingredient of the synergy behind diversification In many ways, knowledge and expertiserepresent the best types of resources on which to build and extend new sources of com-petitive advantage Knowledge and expertise are increasingly intangible (nonphysical)and based in organizational capabilities, meaning that they cannot easily be copied or imi-tated by competitors Over time, competitors can learn the secrets behind new manufac-turing plants and distribution channels, but it is much more difficult to imitate a com-petitor with distinctive knowledge or expertise Knowledge-based assets, such asreputation, marketing know-how, brand names, patents, quality improvement skills, sci-entific testing, and fast product development teams, take time to accumulate and to grow.They are also highly specialized and tend to last a long time This time requirement makesthese characteristics especially distinctive, perhaps even unique, to the firm possessingthem Firms possessing such knowledge and expertise-based resources are well situated

to extend their own distinctive competences into new areas of activity, since the ness of such knowledge makes it hard for competitors to follow rapidly

unique-In the pharmaceutical industry, many leading drug firms are beginning to purchase small,

vibrant biotechnology companies to supplement their own R&D efforts Many small

biotech-nology companies, such as Amgen, Genentech, Immune Response, and others, were formed

by small groups of scientists They were specially trained and skilled in new cutting-edge

technologies, such as genetic and molecular engineering Large pharmaceutical firms’

inter-ests in acquiring many of the smaller biotechnology firms are based on the latter’s distinctive

knowledge and skills, which are essential to developing drugs against cancer, AIDS,

heredi-tary diseases, and other ailments.20Amgen has become a market leader in developing new

forms of biotech-based treatments that help combat blood sepsis and clot formation during

heart attacks It is also a leader in inflammation and soft-tissue repair drugs

Exxon acquired Reliance Electric to realize this kind of technology transfer benefit

Exxon had developed a new energy-saving technology for electric motors called

alternat-ing current synthesis (ACS) This breakthrough had come from Exxon’s long-term effort

to prepare the company for possible future conversion of automobiles from combustion

engines (powered by gasoline) to electric motors (driven by batteries) Exxon reasoned that

the transfer of ACS technology to Reliance would dramatically improve Reliance’s

posi-tion in the electric motor field Unfortunately, ACS technology turned out to be too

expen-sive for commercial application Exxon’s resources (knowledge of petroleum refining) did

not apply to electronics (design and integration) After operating Reliance at breakeven for

several years, Exxon sold the subsidiary at a loss

General Motors’ acquisition of Electronic Data Systems (EDS) in 1986 was motivated

by a similar technology transfer consideration EDS’s core competence is data processing

and systems integration Systems integration helps computers, software, and machines

from different vendors “talk” to one another GM planned to introduce EDS’s computer

systems integration technology to make GM’s factories work more smoothly and more

compatibly, thereby making GM’s factories more responsive and cost efficient when

changing car models or tooling GM reasoned that EDS’s expertise in systems integration

would make its factories more flexible and computer-driven However, the potential

syn-ergies between the two companies never really materialized Ultimately, General Motors

sold off its EDS unit to the public in a complex transaction spanning 1995 and 1996

In the financial services industry, the purchase by American Express of Shearson,

Lehman Brothers, IDS, and other financial firms during the 1980s stemmed from its need

for expertise in investment and merchant banking American Express’s core business was

that of providing high-quality travel and limited financial services to an upscale customer

base By expanding and acquiring Shearson, Lehman Brothers, and E F Hutton during

the 1980s, American Express instantly transformed itself into a leading Wall Street

finan-cial powerhouse A similar motivation prompted Primerica to purchase the Travelers

insurance group in 1993 Now, Travelers has merged with Citibank to form a giant

finan-cial services powerhouse that combines banking, insurance, brokerage, asset

manage-ment, and other operations The combination of the two firms, known as Citigroup, allows

for transfer of expertise and knowledge of financial services, distribution, and other

busi-nesses that are increasingly technological and knowledge-based Citigroup now competes

with megabanks (e.g., Chase, Bank of America) and brokerages (e.g., Merrill Lynch,

Morgan Stanley Dean Witter)

New product expertise like Reliance Electric’s ACS technology, EDS’s system

integra-tion, or American Express’s investment banking skills is not the only kind of expertise that

can be usefully transferred from one business to another Resources in virtually any

func-tional area (production, marketing, human resource management) or core skill

(miniatur-ization, molding technology, packaging, thin-film extrusion) are a candidate for this kind

of transfer These skills ideally should be highly specialized, durable, and applicable to

reinforcing the firm’s distinctive competences Many of these functional area or core skills