Welcome to BA495 Business Strategy and Policy

1. Welcome to BA495Business Strategy and Policy John A. Hengeveld Mary Kay Chess

2. Agenda for Today – short day… • Chapter 1-4 of Grant • Discussion of Simulation/Q&A

3. Strategy as a Quest for Profit • The stakeholder approach : The firm as a coalition of interest groups: pursuit of multiple objectives. • The shareholder approach : The firm exists to maximize the wealth of its owners. • Why is profit maximization a reasonable goal? (1) Boards of directors legally obliged to pursue shareholder interests. (2) To replace assets, firm must earn return on capital > cost of capital (difficult when competition intense). (3) To survive acquisition, firm must achieve stock-market value > break-up value.

4. What is Profit? • Profit maximization an ambiguous goal • Total profit vs. Rate of profit • Over what time period? • Accounting profit versus Economic profit • Economic value added as a measure of economic profit: • Post-tax operating profit lesscost of capital

5. How U.S. Companies Perform Under Different Profitability Measures, 1998 Net Inc. ROS ROE EVA Market Return to Value Added Shareholders ($m) (%) (%) ($m) ($m) (%) General Motors 2,956 1.8 19.7 -5,525 -17,943 21.4 General Electric 6,573 9.4 22.2 4,370 285,320 45.3 Exxon 6,370 6.3 14.6 -2,262 114,774 22.4 Philip Morris 5,450 10.3 39.0 5,180 98,657 64.8 IBM 6,328 7.7 32.6 2,541 -5,878 77.5 Coca-Cola 3,533 18.8 42.0 2,194 157,356 1.3 Wal-Mart 4,430 3.2 21.0 1,159 159,444 107.7 Procter & Gamble 3,780 10.2 12.2 61,661 102,379 15.9 Microsoft 4,490 31.0 27.0 3,776 328,25737.5 Hewlett-Packard 2,945 6.3 17.4 -593 45,464 10.7

6. Value Maximization Maximizing the value of the firm: Max. net present value of free cash flows : max. V = Ct (1 + re)t t Where: V market value of the firm. Ct free cash flow in time t re+d weighted average cost of capital

7. Applying Shareholder Value Maximization to Strategy Choice • Identify strategy alternatives • Estimate cash flows associated with cash strategy • Estimate cost of capital for each strategy • Select the strategy which generates the highest NPV

8. Valuing Companies and Business Units If net case flow growing at constant rate (g) V = C1 ( r - g ) With varying cash flows which can be forecasted for 4 years: V = C0 + C1 + C2 + C3 + VH (1 + r ) (1 + r )2 (1 + r )3 (1 + r )3 where: VH is the horizon value of the firm after 4 years

9. Problems of DCF Approaches to Strategy Approach • Several technical and theoretical problems (e.g. option values) • Estimating cash flows beyond 2-3 year horizon is hazardous---especially in dynamic markets HENCE:- Some simple guidelines for maximizing shareholder value --- • On existing assets-- maximize after-tax rate of return • On new investment-- seek after-tax rate of return > cost of capital

10. The six levers of financial and real options Financial options Real options Comments Present value of returns to the investment The greater the NPV, the higher the option value Stock price = Exercise price The higher the cost, the lower the option value = Investment cost OPTION VALUE Uncertainty Uncertainty Higher volatility increases option values = Time = opportunity to learnabout outcomes Time to expiry Duration of option = Loss of cash flow to fully -committed competitors lowers option value Dividends Value lost over duration of option = Risk-free Interest rate Risk-free interest rate Higher interest rate increases option value by increasing value of deferring investment =

11. Disaggregating Return on Capital Employed COGS/Sales Return on Sales Depreciation/ Sales SGA expense/ Sales ROCE Fixed Asset Turnover Sales/PPE Inventory Turnover Sales/Inventories Sales/Capital Employed Creditor Turnover Sales/Acct Turnover of other items of working capital

12. Linking Value Drivers to Performance Targets Order Size Customer Mix Sales Targets Sales/Account Customer Churn Rate Margin cogs/ sales Deficit Rates Cost per Delivery Development Cost/Sales Maintenance cost Shareholder value creation ROCE New product development time Indirect/Direct Labor Inventory Turnover Customer Complaints Economic Profit Capital Turnover Downtime Capacity Utilization Accounts Payable Time Cash Turnover Accounts Receivable Time CEO Corporate/Divisional Functional Departments & Teams

13. Balanced Scorecard for Mobil N. American Marketing & Refining Strategic Objectives Strategic Measures F I N A N C I A L F1 Return on Capital Employed F2 Cash Flow F3 Profitability F4 Lowest Cost F5 Profitable Growth F6 Manage risk * ROCE * Cash Flow * Net Margin * Full cost per gallon delivered to customer * Volume growth rate Vs. industry * Risk index Financially Strong C O U M S E T R - C1 Continually delight the targeted consumer C2 Improve dealer/distributor profitability * Share of segment in key markets * Mystery shopper rating * Dealer/distributor margin on gasoline * Dealer/distributor survey Delight the Consumer Win-Win Relationship I N T E R N A L I1 Marketing 1. Innovative products and services 2. Dealer/distributor quality I2 Manufacturing 1. Lower manufacturing costs 2. Improve hardware and performance I3 Supply, Trading, Logistics 1. Reducing delivered cost 2. Trading organization 3. Inventory management I4 Improve health, safety, and environmental performance I5 Quality * Non-gasoline revenue and margin per square foot * Dealer/distributor acceptance rate of new programs * Dealer/distributor quality ratings * ROCE on refinery * Total expenses (per gallon) Vs. competition * Profitability index * Yield index Delivered cost per gallon .Vs. competitors * Trading margin * Inventory level compared to plan & to output rate * Number of incidents * Days away from work * Quality index Safe and Reliable Competitive Supplier Good Neighbor On Spec On time L E & A G R R N O I W N T G H L1 Organization Involvement L2 Core competencies and skills L3 Access to strategic information * Employee survey * Strategic competing (?) availability * Strategic information availability Motivated and Prepared

14. A Comprehensive Value Metrics Framework • Shareholder • Value • Measures: • Market value of the • firm • Market value added • (MVA) • Return to • shareholders • Intrinsic • Value • Measures: • Discounted cash • flows • Real option values • Financial • Indicators • Measures: • Return on Capital • Growth (of • revenues &operating • profits • Economic profit (EVA) • Value • Drivers • Sources: • Market share • Scale economies • Innovation • Brands

15. Values and Mission The role of values : • Place constraints on the means by which the firm will pursue shareholder value max. • Increase the effectiveness with which the firm builds competitive advantage though reinforcing strategic intent and building internal consensus and commitment. The role of mission: • Foundation for strategy Statement of what the firm seeks to achieve and what it intends to become.

16. Concentration Entry/Exit Barriers ProductDifferentiation Information Industry Structure PerfectCompetition Oligopoly Duopoly Monopoly Many Firms Few 2 Firms One Firm NoBarriers SignificantBarriers HighBarriers HomogeneousProduct Potential for Product Differentiation PerfectInformation Flow Imperfect Availability of Information Grant: Figure 3.2

17. Porter’s Five Forces of Competition Framework SUPPLIERS Bargaining power of suppliers INDUSTRY COMPETITORS Threat of substitutes Threat of new entrants POTENTIAL ENTRANTS SUBSTITUTES Rivalry among existing firms Bargaining power of buyers BUYERS

18. Threat of Substitutes Extent of competitive pressure from producers of substitutes depends upon: • Buyers’ propensity to substitute • The price-performance characteristics of substitutes.

19. The Threat of Entry Entrants’ threat to industry profitability depends upon the height of barriers to entry. The principal sources of barriers to entry are: • Capital requirements • Economies of scale • Absolute cost advantage • Product differentiation • Access to channels of distribution • Legal and regulatory barriers • Retaliation

20. Bargaining Power of Buyers Buyer’s price sensitivity Relative bargaining power • Cost of purchases as % • of buyer’s total costs. • How differentiated is the • purchased item? • How intense is • competition between • buyers? • How important is the • item to quality of the • buyers’ own output? • Size and concentration of • buyers relative to • sellers. • Buyer’s information . • Ability to backward • integrate. Note: analysis of supplier power is symmetric

21. Rivalry Between Established Competitors The extent to which industry profitability is depressed by aggressive price competition depends upon: • Concentration (number and size distribution of firms) • Diversity of competitors (differences in goals, cost structure, etc.) • Product differentiation • Excess capacity and exit barriers • Cost conditions • Extent of scale economies • Ratio of fixed to variable costs

22. Figure 3.5. The Impact of Growth on Profitability Market Growth Less than -5% -5% to 0 0 to 5% 5% to 10% Over 10%

23. Profitability and Market Growth Return on sales Return on investment Cash flow/ Investment Less than -5% -5% to 0 0 to 5% 5% to 10% Over 10%

24. The Impact of Unionization on Profitability Percentage of employees unionized None 1%-35% 35%-60% 60-75% >75% ROI (%) 25 24 23 18 19 ROS (%) 10.8 9.0 9.0 7.9 7.9 [ROI = Return on Investment ROS = Return on sales]

25. Applying Five - Forces Analysis Forecasting Industry Profitability • Past profitability a poor indicator of future profitability. • If we can forecast changes in industry structure we can predict likely impact on competition and profitability. • Strategies to Improve Industry Profitability • What structural variables are depressing profitability • Which can be changed by individual or collective strategies?

26. Drawing Industry Boundaries : Identifying the Relevant Market • What industry is BMW in: • World Auto industry • European Auto industry • World luxury car industry? • Key criterion: SUBSTITUTABILITY • On the demand side : are buyers willing to substitute between types of cars and across countries • On the supply side : are manufacturers able to switch production between types of cars and across countries • May need to analyze industry at different levels for different types of decision

27. The Value Net CUSTOMERS COMPETITORS COMPANY COMPLEMENTORS SUPPLIERS

28. Five Forces or Six? Introducing Complements The suppliers of complements create value for the industry and can exercise bargaining power SUPPLIERS Bargaining power of suppliers INDUSTRY COMPETITORS COMPLEMENTS Threat of new entrants POTENTIAL ENTRANTS Threat of substitutes SUBSTITUTES Rivalry among existing firms Bargaining power of buyers BUYERS

29. Dynamic Competition Porter framework assumes • industry structure drives competitive behavior • Industry structure is stable. But---competition also changes industry structure Schumpeterian Competition: A “perennial gale of creative destruction” where innovation overthrows established market leaders Hypercompetition: “intense and rapid competitive moves….creating disequilibrium through continuously creating new competitive advantages and destroying, obsoleting or neutralizing opponents’ competitive advantages

30. Applying Five Forces to Emerging E-commerce Markets • The more unstable is industry structure—the less • helpful is analysis based upon industry structure. • Taking account of time—willingness to endure losses • today in order to reap profit tomorrow • General structural features of digital, networked • industries: • Low entry barriers + Extreme scale economies + • Network externalities = Winner-take-all markets • = Intense competition

31. Identifying Key Success Factors Pre-requisites for success Pre-requisites for success What do customers want? How does the firm survive competition • Analysis of competition • What drives competition? • What are the main dimensions of competition? • How intense is competition? • How can we obtain a superior competitive position? • Analysis of demand • Who are our • customers? • What do they want? • What drives competition? • What are the main • dimensions of competition? • How intense is competition? • How can we obtain a • superior competitive position? KEY SUCCESS FACTORS

32. Identifying Key Success Factors Through Modeling Profitability: The Airline Industry Profitability = Yield x Load factor - Unit Cost Income Revenue RPMs Expenses ASMs RPMs ASMs ASMs = x - • Strength of competition on routes. • Responsiveness to cha- anging market conditions • % business travelers. • Achieving differentia- tion advantage • Price • competitiveness. • Efficiency of route • planning. • Flexibility and • responsiveness. • Customer loyalty. • Meeting customer • requirements. • Wage rates. • Fuel • efficiency of • planes. • Employee • productivity. • Load factors. • Administrative • overhead. ASM = Available Seat Miles RPM = Revenue Passenger Miles

33. Identifying Key Success Factors by Analyzing Profit Drivers: Retailing Sales mix of products Return on Sales Avoiding markdowns through tight inventory control Max. buying power to minimize cost of goods purchased ROCE Max. sales/sq. foot through: *location *product mix *customer service *quality control Sales/Capital Employed Max. inventory turnover through electronic data interchange, close vendor relationships, fast delivery Minimize capital deployment through outsourcing & leasing

34. The Contribution of Game Theory to Competitive Analysis • Main value: • Framing strategic decisions as interactions between competitors • Predicting outcomes of compeittive situations involving a few • players • Some key concepts: • Competition and Cooperation—Game theory can show conditions • where cooperation more advantagfeeous than comeptition • Deterrence—changing the payoffs in the game in order to deter • a comeptitor from certain actions • Commitment—irrevokable demployments of resoruces that • give criditability to threats • Signaling—communication to influnece a comeptior’s decision Problems of game theory: Useful in explaining past competitive behavior—weak in prediucting future competive behaoir. What’s the problem? — Multitude of models, outcomes highly sensitive to small changes in assumptions

35. A Framework for Competitor Analysis OBJECTIVES What are competitor’s current goals? Is performance meeting there goals? How are its goals likely to change? STRATEGY How is the firm competing? • PREDICTIONS • What strategy changes • will the competitor • initiate? • How will the competitor • respond to our strategic • initiatives? ASSUMPTIONS What assumptions does the competitor hold about the industry and itself? RESOURCES & CAPABILITIES What are the competitors’ key strengths and weaknesses?

36. Segmentation Analysis: The Principal Stages • Identify key variables and categories. • Construct a segmentation matrix • Analyze segment attractiveness • Identify KSFs in each segment • Analyze benefits of broad vs. narrow scope. Identify segmentation variables Reduce to 2 or 3 variables Identify discrete categories for each variable Potential for economies of scope across segments Similarity of KSFs Product differentiation benefits of segment focus

37. *Size *Technical sophistication *OEM/replacement The Basis for Segmentation: Customer and Product Characteristics Industrial buyers Characteristics of the Buyers *Demographics *Lifestyle *Purchase occasion Household buyers *Size *Distributor/broker *Exclusive/ nonexclusive *General/special list Distribution channel Opportunities for Differentiation Geographical location *Physical size *Price level *Product features *Technology design *Inputs used (e.g. raw materials) *Performance characteristics *Pre-sales & post-sales services Characteristics of the Product

38. Segmenting the European Metal Can Industry

39. Segmenting the World Automobile Market REGION US& Canada W.Europe E.Europe Asia Lat America Australia Africa Luxury Cars Full-size sedans Mid-size sedans Small sedans Station wagons Passenger minivans Sports cars Sport-utility Pick-up trucks

40. Vertical Segmentation & Industry Profit Pools —The US Auto Industry 25% 20 Service & repair Leasing Operating margin 15 Warranty Aftermarket parts Auto manufacturing 10 Auto rental Auto insurance Auto loans New car dealers 5 Used car dealers 0 Gasoline 100% 0 Share of industry revenue

41. SEGMENT Segmentation and Key Success Factors in the U.S. Bicycle Industry KEY SUCCESS FACTORS * Low-costs through global sourcing of components & low-wage assembly. * Supply contract with major retailer. Leading competitors: Taiwanese & Chinese assemblers, some U.S manufacturers, e.g. Murray Ohio, Huffy Low price bicycles sold primarily through department and discount stores, mainly under the retailer’s own brand (e.g. Sears’ “Free Spirit”); *Cost effieciency through large scale operation and either low wages or automated manufacturing. *Reputation for quality (durability, reliability) through effective marketing to dealers and/or consumers. * International marketing & distribution. Leading competitors: Raleigh, Giant, Peugeot, Fuji Medium-priced bicycles sold primarily under manufacturer’s brand name and distributed mainly through specialist bicycles stores; *Quality of components and assembly, Innovation in design (e.g. minimizing weight and wind resistence). *Reputation (e.g. through success in racing, through effective brand management). *Strong dealer relations. High-priced bicycles for enthusiasts. Children’s bicycles (and tricycles) sold primarily through toy retailers (discount toy stores, department stores, and specialist toy stores). Similar to low-price bicycle segment.

42. Strategic Group Analysis A strategic group is a group of firms in an industry following the same or similar strategy. • Identifying strategic groups: • Identify principal strategic • variables which distinguish • firms. • Position each firm in relation • to these variables. • Identify clusters.

43. Strategic Groups in the World Automobile Industry Broad GLOBAL, BROAD-LINE PRODUCERS e.g., GM, Ford, Toyota, Nissan, Honda, VW, Daimler Chrysler REGIONALLY-FOCUSED BROAD-LINE PRODUCERS e.g. Fiat, PSA, Renault, GLOBAL SUPPLIERS OF NARROW MODEL RANGE e.g., Volvo, Subaru, Isuzu, Suzuki, Saab, Hyundai NATIONALLY FOCUSED, INTERMEDIATE LINE PRODUCERS e.g. Tofas, Kia, Proton, Maruti PRODUCT RANGE LUXURY CAR MANUFACTURERS e.g., Jaguar, Rolls Royce, BMW NATIONALLY- FOCUSED, SMALL, SPECIALIST PRODUCERS e.g., Bristol (U.K.), Classic Roadsters (U.S.), Morgan (U.K.) PERFORMANCE CAR PRODUCERS e.g., Porsche, Maserati, Lotus Narrow National GEOGRAPHICAL SCOPE Global

44. Strategic Groups Within the World Petroleum Industry INTERNATIONAL UPSTREAM COMPANIES INTEGRATED OIL MAJORS INTERNATIONAL UPSTREAM, REGIONALLY FOCUSED DOWNSTREAM Premier Oil Enterprise Kuwait Petroleum PDVSA INTEGRATED DOMESTIC OIL COMPANIES • NATIONAL • PRODUCTION • COMPANIES Iran NOC 0 0.5 1.0 1.5 2.0 Statoil BP-Amoco Exxon -Mobil Vertical Balance INTEGRATED INTERNATIONAL MAJORS Pemex Petronas Chevron Royal Dutch -Shell Gp. Phillips ENI Elf-Fina-Total Repsol YPF Indian Oil Phillips Texaco Petrobras ENI INTERNATIONAL DOWNSTREAM OIL COMPANIES Repsol Nippon E.g. Neste Tosco 0 10 20 30 40 50 60 70 80 NATIONALLY-FOCUSED DOWNSTREAM COMPANIES Geographical Scope