The Effects of Integration Strategies on Firm Performance

Transcription

1 MSc. in Finance and International Business Department of Business Administration Author: Selen Gül Advisor: Valerie Smeets An Empirical Study on Danish Manufacturing Firms Abstract: The firms diversification strategy choices and their impact on corporate performance have been the center of attention both empirically and theoretically in the fields of strategy and finance for more than 30 years. However in general, previous studies have analyzed the integrationperformance relationship without differentiating the industries that the firms were operating in, but rather the samples were pooled across industries. The aim of this paper is to investigate the performance effects of vertical, horizontal, unrelated integration and un-diversification strategies, by using a sample of 147 Danish manufacturing companies distinguished among 5 large industries, through the years 2009 to Empirical evidence shows that horizontal (related) integrated companies are outperforming the corporate performance of unrelated diversified firms, and the structure of the market, the level of concentration have varying effects on performance for each type of industry. Out of 5 industries, the manufacture of food products has the highest average performance measure, and the empirical results underline the significant and positive effect of the horizontal integration strategy for the manufacture of food products and manufacture of machinery and equipment industries that were subject to be tested. August 2011 Aarhus School of Business, Aarhus University

2 Table of Contents 1. Introduction Research Questions Structure of the Thesis Literature Review Theories of Vertical Integration Make or Buy Decision The Transaction Cost Theory The Property Rights Theory Benefits and Costs of Contracts The Theory of Relational Contracts Is Vertical Integration Beneficial for the Firm? Empirical Evidence on Vertical Mergers Horizontal Integration Economies of Scale and Scope The Learning Economy Empirical Evidence on Horizontal Mergers Diversification Product Diversification Geographic Diversification The Determinants and Motives for Diversification The Resource-Based View Diversification and Firm Performance Empirical Evidence on Diversification and Firm Performance Development of Hypotheses Methodology Data Construction Sample Selection Variables Measurement Performance Measures (Dependent Variables) Independent Variables Control Variables

3 5.3.Limitations General Descriptive Analysis of Each Industry Manufacture of Basic Pharmaceuticals and Pharmaceutical Preparations Manufacture of Food Products Manufacture of Chemicals and Chemical Products Manufacture of Furniture Manufacture of Machinery and Equipment Industry Comparisons Empirical Findings and Discussion of Results Manufacture of Food Industry Manufacture of Machinery and Equipment Industry Discussion of Results Conclusion References Appendices

4 1. INTRODUCTION In this new era, where technological innovations are growing at a fast pace leading to a more globalized world, corporations are facing a change in their form, structure and scope. These new technologies engendered goods to be produced at lower costs, compared to what organizations could achieve using older technologies. In order to benefit from these production opportunities, firms require reliable supplies of inputs, access to widespread distribution and retail outlets. Based on these necessities, the relationships among manufacturers, their suppliers, and their distributors have been affected by this product line and volume expansion. In relation to this phenomenon, the question of the diversification-performance relation, has been generally the most studied in the literature. The scholars main focus has been on the value enhancing or destructive effects of diversification, and the conclusions vary based on the perspectives of the studies that are conducted. Santalo & Becerra (2008) underline that, while several authors have found strong evidence of trading at a discount for diversified firms, supporters indicate that diversified firms are more productive compared to stand-alone businesses. Moreover, the early contributions of Rumelt (1974) and Penrose (1995) indicate that, as firms diversify into more unrelated areas, a lower performance outcome is more likely. Besides the effects of unrelated diversification and firm value, the companies may initially choose to either vertically or horizontally integrate. Manufacturing firms increasingly choose to vertically integrate; meaning that, rather than relying on independent suppliers, factors and agents, they choose to produce the raw materials themselves and even distribute finished goods. Moreover, new production technologies have given firms the opportunity to exert scope economies by producing a wider range of products at a lower cost, compared to be produced separately, leading them to horizontally integrate. (Besanko et. al, 2007) Through diversification within their areas of business, the companies desire to reduce costs and improve market effectiveness by utilizing economies of scale and scope. Besides these integration strategies, geographic diversification plays a key role in the strategic behavior of the large companies and their corporate performance. The company s expansion to different geographic locations as to different global regions and countries would define international diversification (Hitt et. al, 1997) Its importance comes from the utilization of the foreign market opportunities. The research on diversification and firm value has focused primarily on US and European based companies, without taking the performance effects of vertical and horizontal 3

5 integration into consideration. In addition, there are few studies that have focused on a single country, as Kahloul & Hallara (2010) evaluated the performance effects of the French firms. This paper will evaluate the performance measures by combining the impacts of unrelated diversification and as well as vertical, horizontal integration strategies and remaining undiversified. Moreover, in order to specify the results and overcome the socio-cultural differences among countries, the main focus will be on Danish manufacturing companies and the outcomes are to be evaluated based on five different industries Research Questions Based on the definitions mentioned above, it is crucial to highlight the relationship between firm performance and its level of integration strategies. By extending the study of diversification-firm performance analyzers (Penrose, 1995; Rumelt, 1974; Bettis, 1981), the aim of this paper is to question whether firms with an unrelated diversification, horizontal integration, vertical integration or un-diversification strategy perform better or worse compared to each other, and how these choices affect the firm performance. Prior studies generally have taken the effect of integration strategies homogenous across the industries, whereas this study investigates the effect of the strategies on performance by differentiating the industries. This homogenous approach is neglected since different industries bear different structural characteristics, which will lead to various average profits in each industry (Bettis & Hall, 1982), and the type of concentration and competition within an industry are the leading factors that orientate the companies to integrate or not (Penrose, 1995). The questions to be addressed are as follows: What is the dominant integration strategy that each industry embraces and which one has the highest affect on performance? How does the level of concentration change among the industries and does it have a relation with the strategies chosen? Does the integration strategies have an impact on corporate performance and do these effects differ based on the industries? Does the number of countries the firm is operating in, have an impact on firm operating performance? 4

6 1.2.Structure of the Thesis The next section will highlight the theoretical and empirical findings on the topic. Section 3 develops the hypothesis based on the theoretical and empirical arguments mentioned in the literature review. Section 4 gives in depth information of the methodology used, and Section 5 describes the data collection procedure. Section 6 presents the summary statistics for the industries involved in the study. Section 7 illustrates the comparisons among these industries based on their summary statistics. Section 8 presents the empirical findings and the discussion of the results, and finally, Section 9 makes concluding remarks regarding the study. 5

7 2. LITERATURE REVIEW 2.1.Theories of Vertical Integration Coase (1937) suggests that the introduction of the firm is initially based on the existence of the marketing costs. The number of transactions or the activities of the firm within its boundaries is the determining component in assessing the size of the firm, rather than its output. These boundaries are defined as the vertical boundaries since these activities are related at the various levels of the supply chain. Sudarsanam (2010) defines vertical integration as the combination of successive activities in a vertical chain under common coordination and control of a single firm. (p. 153) Vertical integration defines the activities that the company performs within its boundaries, compared to the purchases from independent firms in the market (Besanko et.al, 2007). In other words, vertical merger replaces two or more independent firms with a single firm, and rather than relying on arm s length market-based transactions or contractual dealings, it internalizes the coordination of the successive activities of the firm. Fan & Goyal (2006) indicate that vertical mergers procure acquiring companies with ownership and control over contiguous stages of production. These mergers allow firms to substitute internal exchanges within the boundaries of the firm for contractual or market exchanges. Although vast amounts of theoretical studies on vertical integration exist, there is inadequate number of empirical work on vertical mergers, and the ones conducted are based on small samples Make-or-Buy Decision Make-or-Buy decisions address the questions of: Why do some firms prefer a vertically integrated structure, while others specialize in one stage of production and outsource the remaining stages to other companies? In other words, should a firm produce its own inputs, buy them in the spot market or preserve the relationship with a specific supplier. This decision determines the firm's level of vertical integration, since every decision identifies which operations the firm will engage in and which it will outsource from the suppliers (Walker & Weber, 1984). This notion is concerned with the decision whether to integrate backwards, which is to internalize production of an input rather than source it from an external supplier. (Sudarsanam, 2010, p. 158) Therefore the make part of the decision emphasizes that ownership is joint and control rights are integrated, whereas under the latter, they are separate. Moreover, the costs and benefits of either alternative have to be taken into consideration. For instance, this choice may depend on a range of factors such as; the current and future availability of spot markets for arm s length transactions, the cost of sourcing from 6

8 the spot market, the direct and indirect costs of contracts and informal arrangements, uncertainty and information asymmetry between buyer and seller and indirect costs of internalizing production. (p.158) Based on these factors, the company can choose to perform the activities in-house or buy them from the specialists in the market that are called market firms (Besanko et. al, 2007). There are many advantages and disadvantages of using the market firms to source the upstream activities in the vertical change. The benefits would be achieving scale and learning economies, as well as efficient division of labor and specialization from the supplier s side. On the other hand, the downsides would be the issue in coordinating the production process, the leak of private information, agency and influence costs, moral hazard and disincentives for innovation The Transaction-Cost Theory The transaction costs theory (TC) can be traced back to Coase (1937) who indicated that the production will take place within the firm when the cost of organizing the production through the market exchange is larger than within the firm. In other words, the firms may avoid the costs of transacting with the market firms by carrying out the activity in-house. This cost of transacting with independent market firms is defined by Coase (1937) as the cost of using the price mechanism. The size of the firm will be based on the cost of using the price mechanism, in which a firm will tend to expand until the costs of organizing an extra transaction within the firm become equal to the costs of carrying out the same transaction by means of exchange on the open market or the costs of organizing in another firm. (p. 395) Leiblein & Miller (2003) argue that, although the applicants of the theory generally assume that markets ensure a more efficient mechanism for exchange compared to the hierarchy, in certain situations the costs of the market exchange may be too high and surpass these efficiencies procured by the market. Therefore, the theory focuses on determining the features of exchanges that are best suited to the firms and the market. Williamson (1975) indicates that these inefficiencies originate from small numbers of bargaining situations. Due to the bounded rationality of decision-makers, the asymmetric distribution of relevant information, and the inability to completely specify behavior in the presence of multiple contingencies, the theory maintains that all contracts are incomplete and therefore subject to renegotiation and the possibility of opportunistic behavior. (Leiblein & Miller, 2003, p. 842) Opportunistic behavior is more apparent, when an exchange demands one or more parties to get involved in 7

9 significant transaction-specific investments, which in turn create quasi-rents 1 that, may lead to hold-up 2. Such relation-specific investment creates difficulty in switching to a new customer due to the increases in costs, thus locking the supplier into that relationship (Sudarsanam, 2010). Besanko et al. (2007) and Sudarsanam (2010) are underlining the types of specificities as; site, physical characteristics, dedicated assets and human assets specific. Therefore, based on these downsides of contracts, vertical integration is thought to be beneficial, where hold-up concerns are severe. Firms are expected to depend on in-house production when the transactions are complex, specific investments are included, those specific assets are unceasing, the quality of those assets are hard to be verified, the environment is uncertain and when the quasi-rents based on the relationship are large The Property-Rights Theory The property-rights theory, which has been developed by Grossman & Hart (1986), emphasizes how asset ownership can change investment incentives. They propose two types of contractual rights as; the specific rights and residual rights of control. When it is too costly for one party to specify a long list of the particular rights it desires over another s party s assets, it may be optimal for that party to purchase all the rights except for those specified in the contract. (p. 692) The purchase of the residual rights of control is called ownership. All the residual control rights of the physical assets in question are held by the entity under integration, whereas under non-integration, the assets are owned individually (Hubbard, 2008). Moreover, Grossman & Hart (1986) present that the allocation of residual control rights to one party strengthens the investment incentives of that party, while weakening the counter party s investment incentives. Integration shifts the incentives for opportunistic and distortionary behavior, but it does not remove these incentives. (p. 716) Therefore, both costs and benefits from integration will exist. One of the concluding remarks of Grossman & Hart (1986) is that, integration is suggested when one party s investment incentives is relatively more important to the other firm s incentives. On the other hand, when both investment decisions are equally and somewhat crucial, non-integration is preferable. Compared to the TC literature, the PR literature does not underline the ex post haggling, renegotiation and opportunistic behavior. Instead it stresses contractual incompleteness and develops formal models that show how ex post bargaining affects ex ante investment in non-contractible assets. (Lafontaine & Slade, 2007, p. 650) Kim & Mahoney 1 Quasi-rent would be the extra profit that you get if the deal goes ahead as planned, versus the profit you would get if you had to turn to your next-best alternative. (Besanko et. Al, 2007, p. 126) 2 The term hold-up will be explained more in detail under section

10 (2005) further indicate the importance of property rights theory, as that various specifications of property rights arise in response to the economic problem of allocating scarce resources, and how it affects the economic behavior and economic outcomes in return Benefits and Costs of Contracts According to the theories mentioned above, the existence of market failures may lead the firms to source its inputs from suppliers by negotiating contracts. The duration of these contracts may be short or long-term in nature. Williamson (1971) introduces three alternatives to be considered: a life time contract, a series of short-term contracts, and vertical integration. The once-for-all type of contracts are facing the dilemma of the redesign issues due to changing technology, in which sequential decision process is needed. If, however, contractual revisions or amendments are regarded as an occasion to bargain opportunistically, which predictably they will be, the purchaser will defer and accumulate adaptations, if by packaging them in complex combinations their true value can better be disguised; some adaptations may be forgone altogether. (Williamson, 1971, p. 116) Therefore, short-term contracts may be more preferable due to sequential decision making and adaptation. However, the downsides would be the necessity of relation-specific investments and the existence of a first-mover advantage for one of the parties (Williamson, 1971). These downsides would generate the hold-up problem or behaving opportunistically, in which it occurs when one of the parties would attempt to renegotiate the terms of the contract. The party that has been held-up could be either the buyer or the supplier, but most likely the one that has engaged in a relation-specific investment (Besanko et. al, 2007). In order to eliminate this hold-up problem, Williamson (1971) suggests the firms to vertically integrate, in which the disadvantages of long and short term contracts would be avoided. Sequential adaptations become an occasion for cooperative adjustment rather than opportunistic bargaining; risks may be attenuated; differences between successive stages can be resolved more easily by the internal control machinery. (Williamson, 1971, p. 116) Besides the solution of vertical integration, only a complete contract can eliminate opportunistic behavior. Besanko et al. (2007) argue the applicability of complete contracts, and underline that this type of contracts would be feasible only if the parties are able to specify each contingency to be occurred and the set of actions to be taken. Therefore, contracts in the real-world are incomplete, which involve some degree of open-endedness or ambiguity. The literature on transactions costs highlights that incomplete contracts can cause a non-integrated relationship to yield outcomes that is inferior compared to complete 9

11 contracts. The three fundamental factors preventing to achieve complete contracting are; bounded rationality, difficulties specifying or measuring performance and asymmetric information The Theory of Relational Contracts In relation to this phenomenon of contracts, the third insight is formed by Baker et al. (2002) indicating that relational contracts are informal agreements and unwritten codes of conduct that powerfully affect the behaviors of individuals within firms. (p. 39) These relational contracts affect the behaviors of firms in their business relations with other firms, whether vertical or horizontal. Baker et al. (2002) underline in their study the ease of relational contracts between and within the firms, compared to the difficulties encountered in formal contracting. For example, a formal contract must be specified ex ante in terms that can be verified ex post by the third party, whereas a relational contract can be based on outcomes that are observed by only the contracting parties ex post, and also on outcomes that are prohibitively costly to specify ex ante. (p. 40) Therefore, a relational contract empowers the parties to exploit their detailed knowledge to their particular situation and to adapt this situation to new information as it becomes available. Based on these advantages of relational contracts, the authors are adding dynamics to the previous models and illustrate how these dynamics will affect the vertical integration decisions by introducing game theory models such as; trust games, repeated trust games and trigger strategies Is Vertical Integration Beneficial for the Firm? According to Sudarsanam (2010), vertical integration increases technical efficiencies in some ways; however arises inefficiencies in some other ways. The author describes these technical efficiencies as coordinating, monitoring, and enforcement in the process of production. On the other hand, interdivisional rivalry may lead to opportunism and an increase in influence costs. Moreover, information asymmetry in integrated firms may exist between various levels of management and divisions. In particular, a firm that purchases its supplier, thereby removing residual rights of control from the manager of the supplying company, can distort the manager's incentives sufficiently to make common ownership harmful. (Grossman & Hart, 1986, p. 692) When the residual rights are captured by one party, they are lost for the contrary party that may lead to distortions. On the other side, by vertically integrating no alternative use of the good will exists, leading to a value of zero quasi-rent and no hold-up problems (Williamson, 1971). 10

12 Empirical Evidence on Vertical Mergers The efficiencies of vertical integration have been subject to be tested by several scholars in order to illustrate why firms take parts production in-house and what types of specificities are affecting vertical integration (Monteverde & Teece, 1982; Masten, 1984), and how the duration of the contracts are affecting the choice to vertically integrate (Joskow, 1985). Monteverde & Teece (1982) have explained vertical integration by examining the U.S. automobile industry for the two firms, GM and Ford. The study observed a significant and a positive effect on the engineering effort and specificity coefficients, meaning that a high level of engineering effort and the specificity of the component will more likely lead the component to be produced in-house. GM and Ford are more likely to bring component design and manufacturing in-house if relying on suppliers for preproduction development service will provide suppliers with an exploitable first-mover advantage. (p. 212) Moreover Masten (1984) has followed a similar approach by analyzing the variables on vertical integration by using a sample from the U.S. aerospace industry of 1,887 aerospace components. The author has found a significant positive effect for specialization and complexity coefficients, in which the higher the complexity and specialization of the inputs, the higher the probability to vertically integrate. In addition, Joskow (1985) has conducted a study by examining the U.S. coal-burning electric generating plants in order to identify the role of contract duration on vertical integration decisions. The author points out that the variation in the contract duration is based on the level of relation-specific investments, in which longer commitments are engaged where relation-specific investments are more important. Moreover, in the studies of Fan & Goyal (2006), the authors give the basic idea of a vertical merger as, the two industries are vertically related if one of the firms uses the other s output for its own production or if the firm can supply its product or services as the other s input. This measure can be captured by Input-Output tables and is applicable to measure the vertical relations in large samples. Therefore, where merging firms are from the same Input-Output industries, the merger is categorized as vertical. Moreover Sudarsanam (2010) specifies that the empirical evidence on vertical mergers and their value effects is rare, compared to the ones that have analyzed horizontal and diversifying mergers. Colangelo (1995) has studied the effect of pre-emptive merging for vertical vs. horizontal integration and underlined that the overall gain from a vertical integration is generally greater than that from a horizontal integration. In our context vertical integration gives rise to three different gains: (a) it eliminates double marginalization; (b) it 11

13 enables price discrimination against non-integrated rivals; (c) it avoids the loss coming from being non-integrated after a horizontal merger. (p. 324) In addition, the findings of Leiblein & Miller (2003) regarding the semiconductor industry point out that, the vertical boundary choices are affected significantly depending on the firm-level competences and strategies. For instance, the companies with greater experience in a specific type of technology have the tendency to internalize the manufacturing activities than firms without such production knowhow. Similarly, firms with high levels of sourcing experience are more likely to outsource their production than firms that do not have such experience. (p. 854) To sum up, firms internalize transactions when it is expected that they will need to renegotiate supplier contracts due to high asset specificity. 2.2.Horizontal Integration Besanko et al. (2007) indicate that a firm s horizontal boundaries determine the quantities and varieties of products and services that it produces. It refers to a merger of two or more firms producing the same good under one consolidated firm (Chakravarty, 1998). Horizontal boundaries vary obviously across industries and across the firms within them. The optimal horizontal boundaries of the firms are appertaining crucially to economies of scale and scope. Economies of scale and scope exist whenever large-scale production, distribution, or retail operations have a cost advantage over smaller operations. Economies of scale and scope not only affect the sizes of the firms and the structure of markets, but they are also central to many issues in business strategy. (Besanko et al., 2007, p. 75) Economies of scale and scope are the essence for merger and diversification strategies. They have an effect on entry and exit, pricing, and the capability of the firm to protect its long-term sustainable advantage. Sudarsanam (2010) underlines that, a number of firms in wide-ranging sectors such as utility, electricity, banking, pharmaceuticals, insurance, oil and gas, automobiles, food and drinks, steel and healthcare have merged with one another, in the recent years. Such mergers are defined as horizontally related mergers. Where the firms selling the identical product merge, it is described as a pure horizontal merger. Where firms selling products that are not identical in terms of end use but nevertheless share certain commonalities, such as technology, markets, marketing channels, branding or knowledge base, merge, we refer to such mergers as related mergers. (p.123) For simplicity, Sudarsanam (2010) refers to the 12

14 term horizontal merger as to both pure horizontal mergers and related mergers 3 of firms selling a range of similar products. Horizontal mergers often qualify industries and markets whose products are generally in the mature or declining stages of the production life cycle. These markets have a low overall growth rate, and firms have accumulated production capacity that far exceeds the demand. This combination of low market growth and excess capacity engenders difficulties on firms to attain cost efficiencies through consolidating mergers. Such efficiencies may be achieved from scale, scope and learning economies Economies of Scale and Scope The origin of costs may have crucial inferences for industry structure and the behavior of the companies. Besanko et al. (2007) denote that the production process for specific good or service exhibits economies of scale over a range of output when average cost declines over that range. (p.75) Moreover, economies of scale exist if the firm attains unit-cost savings as it raises the production of a given good or service. In order to achieve these scale economies, the associated costs, risks and the extent of cost savings have to be taken into notice (Sudarsanam, 2010). Therefore, firms should be conscious about diseconomies of scale, which arise from complexities of monitoring, diffusion of control, ineffectiveness of communication, and numerous layers of management. In addition to these disadvantages, Besanko et al. (2007) also underline the limits to economies of scale, in which beyond a certain size, bigger is no longer better and may even lead to worse outcomes. The most important reasons for these limits are; labor cost and firm size, conflicting out, spreading specialized resources too thin, and incentive and bureaucracy effects. Moreover, economies of scale may be more crucial for the manufacturing organizations, since the high capital costs of plant need to be recovered over a high volume of output. (Johnson et al. 2008, p. 99) The manufacturing sectors that have been generally important have been motor vehicles, chemicals and metals. In terms of distribution and marketing other industries such as drinks, tobacco and food, the scale economies would be crucial (Johnson et al. 2008). Economies of scope exist, if an increase of production in the variety of goods and services saves the firm from the costs it bears. Whereas economies of scale are usually defined in terms of declining average cost functions, economies of scope are usually defined in terms of the relative total cost of producing a variety of goods and services together in one firm versus separately in two or more firms. (Besanko et al., 2007, p. 76) In other words, Panzar & Willig (1981) point out to the existence of economies of scope where it is less 3 This paper will handle related diversification under the term horizontal integration. 13

15 costly to merge two or more product lines in one firm compared to supplying them separately. Based on the definitions above, scope economies are available only for multi-product firms. Certainly, both economies may be recognized by the increase of the output of individual products as well as the total output of all the firm s products. The research on the extent of scope economies is scarce, in contrast to the literature on scale economies. One possible explanation is that until recently product costing did not allocate costs to the different products correctly, based on the related activities. Activity-based costing (ABC) mitigates this issue; however the problem of how to compare these product costs in the merged firm with the costs on the similar products produced separately by different companies still exists (Sudarsanam, 2010) The Learning Economy Experience is an important determinant to fulfill the tasks faster and attain the output. The magnitude lies under the idea of the learning curve. Besanko et al. (2007) determine that economies of scale points out to the advantages that flow from increase in production to a larger output at a given point in time. The learning curve refers to advantages that flow from accumulating experience and know-how. (p. 94) Sudarsanam (2010) specifies that the economy of learning comes to light when workers and managers become more experienced and effective over time in using the available resources of the firm, and help decrease the cost of production. The time required to do a job will decrease each time the job is done, that the time per unit will decrease at a decreasing rate, and that the time reduction will be predictable. (Lindsey & Neeley, 2010, p. 73) It is a function of cumulative output over several periods, and increasing cumulative output raises the motivation to learn more efficient and effective ways of producing each unit of the output for the managers and workers. Employees learn not only from their personal experience but also from that of their colleagues. The limit to learning and its affect on cost reduction is designated by the minimum efficient learning scale (MELS). At this level, maximum learning has been procured (Besanko et al., 2007). Based on the studies conducted, the semiconductors and aircraft production are some of the industries that the learning economy may be more crucial. The learning rates averaged about 20 to 40 percent respectively. Learning curve efficiency entails that the firms have a large sales quantity and therefore a relatively large market share. Therefore, the cost of acquisition of the increased market share needs to be balanced against the subsequent cost savings from increased learning efficiency. (Sudarsanam, 2010, p. 138) Moreover, Besanko 14

16 et al. (2007) emphasize that learning occurs at different rates for different organizations and processes, according to the variation in slopes across firms and products. Although organizational learning is highlighted as the essence of the process, primarily it is individuals who learn. While individuals do the learning, the firms can take the steps to enhance learning and the maintenance of knowledge in the organization. Horizontal mergers lead to the consequence of a sudden increase in the quantity of output when the output of each merging firm is combined. While each firm has the opportunity to learn from the experience of the other firm, this learning may not engender the cumulative output of the merged entity to increase more. In the period subsequent the merger this output may increase, hence creating opportunity for further learning. However, if the output of the merged company is already large, it is expected to have passed the minimum efficient learning scale (MELS) of cumulative output (Sudarsanam, 2010). For instance, mergers involving complex technological processes such as drug discovery may yield potentially valuable learning opportunities, but they are also problematic because of the coordination and management problems. (p. 139) Empirical Evidence on Horizontal Mergers Lipczynski et al. (2005) signify that the empirical evidence on the increased profitability through increased market power or cost savings of horizontal mergers is rather conflicting and inconclusive. For instance, Cosh et al. (1980) examine 211 mergers in the UK between the years 1967 and 1969, comparing profitability during a five-year period before the merger, with profitability during the five years subsequent the merger. The merged firms are observed to have experienced an increase in average profitability. On the contrary, Meeks (1977) detects a fall on average profitability during the seven-year period following the merger in a study of mergers in the UK between 1964 and In addition to these studies, Ravenscraft & Scherer (1987) examine the pre-merger profitability of 634 US target firms in the late 1960s and early 1970s. The target firms profitability (the ratio of operating income to assets) was observed to be 20 percent, which is much greater than the average profitability of all firms of 11 percent. Moreover, Weiss (1965) inspects the impacts of horizontal mergers on seller concentration for six manufacturing industries for the period Changes in concentration ratios over approximate 10-year intervals are decomposed into effects arising from the internal growth of firms, the exit of incumbent firms, mergers, and turnover or changes in the identity of the largest firms in each industry. (Lipczynski et al., 2005, p. 263) 15

17 Therefore, internal growth and exit seem to have a more crucial role than mergers in affecting the changes in concentration. Finally, Colangelo (1995) underlines the gains from horizontal integration as: it leads to an increase in the market power due to the internalization of the cross-price effect on demand, and it prevents the loss coming from being non-integrated after a vertical integration. 2.3.Diversification The incentive and consequences of diversification on firms has been committed to a vast amount of studies by both economists and business researchers. However, these two groups approached the phenomenon from different perspectives. Economists have treated the extent of a firm s diversification as determined by structural variables in the industries in which the firm operated and the economics of the organization of activity within the firm operated and the economics of the organization of activity within the firm compared to via the market. (Lecraw, 1984, p. 179) On the other hand, business researchers have paid attention on the human and physical assets of the firm, by taking its internal strengths and weaknesses into consideration in determining its diversification strategy. This paper will have the focus of the economists perspective in identifying the companies diversification strategies, in which the structural variables of the industry and the activity of the firm within this industry will be highlighted. Lipczynski et al. (2005) define a diversified firm or a conglomerate as; to being involved in the production of a number of various goods and services, making it a multiproduct firm. According to the authors, the types of diversification can take the forms as product extension, market extension and pure diversification. Product extension would be achieved if a firm can diversify by producing a new product that is strongly related to its existing products. Market extension involves diversifying into a new geographic market with the same line of products, and a pure diversification strategy involves a transition into unrelated areas of business activity. Rumelt (1982) depicts the first and the last components of the strategies respectively as related 4 and unrelated business companies. Lipczynski et al. (2005) further indicate two ways in which a diversification strategy can be performed; either through internally generated expansion, or through mergers and acquisitions. Conglomerate merger involves the integration of firms that operate in different product markets, or in the same product market but in different geographic markets, whereas internally generated expansion is likely to require the simultaneous extension of the firm s 4 Recall that this paper takes related diversification strategy under the name of horizontal integration. 16

18 plant and equipment, workforce and skills base, supplies and raw materials, and the technical and managerial expertise of its staff. (p. 593) Diversifying through a conglomerate merger may be less demanding in this matter Product Diversification As indicated above, the strategies of related and unrelated integration are defined under product diversification. Although this paper will refer to the concepts as horizontal integration and unrelated integration strategies, it is worth mentioning this broad definition and its performance effects. Ravichandran et al. (2009) notes that, product diversification which illustrates the scope of the multiple and distinct product markets that the firm is operating in, has been lately under the focus of strategic management researchers. Geringer et al. (2000) indicate the relationship of performance and the product mode of diversity is well established by studies in two related directions type of diversification and degree of diversity. (p. 54) Rumelt (1974) found differences across his relatedness categories, in the seminal study of qualitative types of diversification. The author divided the integration strategies into 7 categories; which were single business, dominant vertical, dominant constrained, dominant linked-unrelated, related constrained, related linked and unrelated business. In order to specify the strategy that a company possesses, Rumelt (1974) constructed intervals of ratio specification. Based on these intervals of ratios (specialization ratio, related-core ratio, related ratio and vertical ratio) the companies strategies were specified. Following studies using his methodology have generally underlined that related diversification generated higher performance levels than unrelated diversification, although industry effects and other firm-level variables tend to eliminate much of the effect of the diversification type. Therefore, the general outcome of the studies is that related diversification is associated with a profitability advantage (Geringer et al., 2000) Geographic Diversification Geographic diversification is identified as the firm s expansion into various geographic locations or markets across the borders of regions and countries (Hitt et al., 1997). Thus, a firm's level of international diversification is reflected by the number of different markets in which it operates and their importance to the firm (as measured, for instance, by the percentage of total sales represented by each market). (p. 767) This type of diversification strategy has its motivations as well as downsides. Denis et al. (2002) identify several motivations as; global diversification is a mechanism that combines the information- 17

19 based assets of buyers and sellers within the same firm. It generates value by creating flexibility within the firm, by giving the ability to respond to changes in relative prices. In addition, investors diversification choices can result as the benefit of geographic diversification. Ravichandran et al. (2009) adds the scope and scale economies, enhanced market power, and the ability to supply lower-cost factor inputs to the benefits of global diversification. Moreover, increased operational flexibility by global diversification reduces the risks across the markets. (Kim & Mathur, 2008, p. 749) However as from the downside perspective, a globally diversified entity is more complex compared to a purely domestic firm. The costs of information asymmetry between corporate headquarters and the difficulty of monitoring managerial decision-making may give rise (Denis et al., 2002). Based on the empirical studies conducted, Ravichandran (2009) and his colleagues specify that, multinational corporations (MNCs) experienced a positive valuation effect relative to purely domestic firms because of their role as financial intermediaries. (p. 210) Moreover, Lepetit et al. (2004) illustrate that the announcements of the mergers and acquisitions beyond regions and countries have a positive effect on the market. On the other hand, the effect on firm performance may be negative due to high transaction costs and managerial-information processing demands. Moreover, Delios & Beamish (1999) have found a positive relationship between the geographic scope and firm s performance by collecting a data of 399 Japanese manufacturing firms. Their findings illustrate that expanding into new geographic markets is an effective strategy for developing the performance of Japanese companies. However, in the study of Kim & Mathur (2008) where a sample of 28,050 firm year observations from 1990 to 1998 was used, a firm value decrease was associated for both industrial and geographic diversification. We find that geographically diversified firms have higher R&D expenditures, advertising expenses, operating income, ROE and ROA than those of industrially diversified firms. (p. 764) The Determinants and Motives for Diversification In exploring the determinants of diversification, Rondi et al. (1996) focuses on three theories of diversification. The first, attributed to Marris (1964) and Penrose (1995), propose that the managers seek to maximize the growth of the firm. The operation of specific assets such as marketing skills and technical enterprise in other industries offers a convenient vehicle in order to achieve the growth objective. The second theory attributed to Bain (1959), puts emphasis on the conditions that yield entry possible or attractive. These incorporate industry-level characteristics such as growth and concentration, average profitability, as well 18

20 as barriers to entry. The third theory, attributed to Rumelt (1974) and Williamson (1975), focuses on relatedness between industries that makes diversification attractive, in which relatedness refers to the similarities between markets, technologies, and organizational structures (Lipczynski et al., 2005). The scope of this paper generally refers to the third theory where relatedness is the underlying concept. As mentioned above under the heading of horizontal boundaries, related diversification represents the horizontally integrated mergers. Therefore, this part will consider the value creation for the acquisitions of unrelated businesses. Sudarsanam (2010) underlines the motives of value creation as having an increased market power or operating an efficient internal capital market. Market power is the ability of a firm in a market to pursue anticompetitive behavior against its current rivals or potential entrants. (p. 184) This power is not obtained from the monopoly position in that market, but from the range of the firm s activities and its size. Based on this market power, the conglomerates assign investment funds to a wide range of individual entities. If these entities were stand-alone, independent firms, their funds would be supplied directly from the capital markets. Thus, the conglomerate firm serves the role of capital markets. The firm will create value, in case it possesses an effective performance compared to the external capital market. Moreover, Lipczynski et al. (2005) add more motives such as; saving costs, reduction of transaction costs and the managerial motives for diversification The Resource-Based View A vast amount of the management literature on diversification follows the resourcebased view of the firm. The resource view argues that rent-seeking firms diversify in response to excess capacity in productive factors, here called resources. (Montgomery, 1994, p. 167) Under this perspective, firms acquire companies to keep the balance among the required competitive profile and competences, and their current endowments of resources. However, the amount of resources available are limited, therefore firms are not limitless in their ability to pursue new investment opportunities (Wiersema & Bowen, 2008). Apart from this limitation, conglomerate acquisition may be undertaken by the same motives for acquiring competitive profile and competences. Other reasons may be the need for growth, and to utilize the excess capacity the firm possesses. These idle resources should be reused in more productive and profitable areas. Therefore the question to be answered is, how best the firm can exploit these resources outside of its current operations. In the book of Silverman (2002), three sets of factors are pointed out as the firm s diversification behavior. Initially is 19

21 the specific range of applications to which the firm s current resources may be useful. These depict the possible set of businesses in which the firm s resource base will provide competitive advantage. The second is the scope of transaction costs in the relevant markets for the firms existing resources. These determine the firm s ability to exploit its resources through contractual arrangements, which can prevent the need for expansion of the firm s boundaries. The third set of factors deal with the sustainability of the competitive advantage furnished by the firm s resources. For the reason of prioritization, a firm will decide on to focus first on the exploitation of those resources that offer the most sustainable competitive position, since it cannot use all of its resources at once. Finally, in order to generate sustainable competitive advantage, it has been argued that firms resources and capabilities should be rare, valuable, difficult to imitate, non-substitutable and non-transferable in that they cannot be easily purchased in resource markets. (Matraves & Rondi, 2007, p. 38) Diversification and Firm Performance Firm diversification has been extensively researched both empirically and theoretically in the fields of strategy and finance for more than 30 years. The literature on diversification generally focuses on the economic rationale behind the diversificationperformance relationship, and the main common objective of this work has been to verify the effect of diversification on the creation or destruction of firm value. Thus, the researches center of attention has been on the performance of the diversified firms compared to specialized firms (Santalo & Becerra, 2008). Many researchers have studied the effects of operating performance on diversified firms compared to undiversified, which is measured by accounting profits or productivity. They have found the relationship between performance and corporate diversity to be ambiguous. Profits were more likely to be determined by industry profitability, coupled with how the firm related new businesses to old ones, rather than diversification per se. (Besanko et al., 2007, p. 180) Ravichandran et al. (2009) specify that firms may choose to diversify into related or unrelated markets, based on the similarity or relatedness of the new business. Related diversification is believed to lead to better performance than unrelated diversification because the former leverages significant business synergies while the latter suffers from agency costs and inefficient resource allocation. (p. 206) This belief has been widely studied by many scholars. Prahalad & Bettis (1986) explain this logic more in depth, by indicating the four major and nine minor categories that Rumelt (1982) has used to identify the diversification 20