Wednesday, November 30, 2011

Why Google wants to grow

Companies often justify growth as a strategy to improve profitability. Growing allows companies to obtain economies of scale and rise on the learning curve. In addition, a larger market share will allow a company to influence pricing more effectively. In economic context it is assumed that companies are seeking to maximize profits. The motivation for growth however is not always as straightforward as managers would like it to be perceived. This paper will discuss several growth strategies and reasons for firms to grow. Once the different strategies have been discussed, these will be applied to Google, based on a recent article that discusses Google’s intention to purchase Motorola. The paper will reflect upon the views that this purchase may be anti-competitive, what Google’s motivation is and whether this strategy will yield the expected results.

A company can grow by doing more of the same (horizontal growth), reducing it’s trading relationships by taking over some of these functions themselves (vertical growth) or start operating in a different market (diversified growth). Depending on which strategy will generate the most profit, a company chooses one or more of these strategies. Growth can be organic, which means the company increases sales from within or growth can be acquisitive. Acquisitive growth is the opposite of organic growth, meaning that a company will buy (and sell) businesses in order to grow.

Organic growth is generally seen as more valuable, as there are some pitfalls with acquisitive growth. For example, DHL grew tremendously by acquisitions only to realize at the end that they were operating as individual companies across the globe, never taking advantage of the economies of scale. A merger or acquisition however does reduce the amount of competitors in the market by definition. This will most likely reduce the price elasticity, decrease the likeliness of price wars and thus lead to more chances of increasing prices.

Horizontal growth is generally related to reducing costs. When a firm increases its scale of operation by increasing capital, this usually leads to average costs to drop. This is often the reason companies decide to merge. As mentioned in the example above, sometimes companies become too large and lose this advantage by losing control and co-ordination. This effect of (dis)economies of scale is shown in graph 1.[i]  Other advantages from horizontal growth come from the learning curve, as shown in graph 2[ii]. As the firm produces more units, average costs drop because the company learns how to produce more efficiently.

Graph 1, (dis)economies of scale                                                          
  Graph 2, learning curve[iii]


       

Vertical growth is an attempt to integrate value-adding activities into existing activities, such as production of raw materials. This can reduce production costs by reducing transportation and costs affiliated with the transaction. Transaction costs are costs incurred by trading and organizing a transaction. Besides the cost effects, vertical growth can also be a strategic decision. In some cases there may be a hold-up problem, leading to an external producer’s unwillingness to invest in a production facility. This is often seen in the car industry, resulting in the manufacturer producing its own parts. Integration can also lead to a competitive advantage. A brewer can for example buy pubs and promote their beer in these pubs providing higher sales for the brewer. Owning the pubs also gives the brewer negotiating power with other brewers, leading to higher margins for the pubs and in turn again for the brewer. Vertical integration is mostly interesting when transaction costs are high, economies of scale are not of importance for the process or when it creates strategic advantage.

Diversified growth occurs when a company enters different markets and generally tries to obtain economies of scope. Google is a company that has very successfully integrated this concept into their business model. Since their servers and network is up and running for its’ search engine, adding Gmail, Google Docs, and many other services was a logical step. The cost for maintaining these networks together is lower than running these networks independently, and it binds its customers to the company. Diversification also reduces risk. If a company operates in one market, and this market becomes more competitive or irrelevant, than that could lead to serious distress for the company. If the company is also operating in other markets then it could potentially offset these loses by the profits in the other market. Coffee middlemen were an example of those who traded in only one field. When the producers of coffee started trading directly with the farmers, they lost all their business. It must be noted that even though diversification can lead to financial benefits for a company, this does not necessarily hold for the shareholders. Shareholders can easily diversify at low cost by investing in different companies that have a low correlation, following the modern portfolio theory.[iv]

Overall, growth in its different forms should be linked to profit maximization either in the short or long run and must offer revenue opportunities or cost reductions. Sometimes growth is a strategy to diversify against risk, however as stated before this is usually benefits the managers/employees more than the shareholders. Growth is also a tool to avoid ‘shrinking’. When the entire market around a company grows and the company does not, its relative size will be smaller. This may lead to competitors being able to make better use of economies of scale and gaining competitive advantage. A larger company will usually be able to withstand economic turmoil better, because of its stronger pricing influence. Generally, organic growth is preferred over acquisitive growth and management should choose the growth strategies that maximize a company’s profit.

The recent offer from Google to acquire Motorola follows Google’s diversification strategy. The synergy that may be created, if Google and Motorola integrate their businesses effectively, will help to maximize Google’s and Motorola’s profits. The purchase will enable Google to produce tablets & phones directly, overcoming their integration problems. The merger will allow Motorola to compete better with the larger competitors such as Nokia, Apple and Samsung. An article in the Economist substantiates this[v] claim. For the shareholders of Motorola the 60% premium on the stock price seems more than fair, as the average premium paid is around 20% to 25% in Europe[vi].

Reviewing the evidence on mergers and acquisitions[vii] in literature (D. Ward, D. Begg) the stock price for the buying firm often stagnates or even falls post-merger, and the results from the studies show that mergers are not always a good idea as the previous mentioned example of DHL proves. The reason behind the pursuit of this acquisition could be the interest of the managers of Google instead of profit maximization. Manager’s pay tends to increase after a merger. RBS and ABN AMRO are a famous example[1] where the Dutch, British and Belgian states later had to intervene to avoid bankruptcy. The fact that Google’s decision cannot be seen as ‘rationalization’, as it states it will run Motorola independently and thus not sharing any of the supporting functions, hints that the agency theory[viii] may hold here.

Google had been facing patent litigation and issues with the integration of the software with the hardware of the different producers. Motorola owns many patents, which may help Google in court, as Google had no patents before the acquisition[ix]. As mentioned before, owning a handset-maker will allow smoother integration of the hard- and software.[x] Motorola also produces other consumer electronics, suggesting that Google could further broaden its scope. The merger suggests that the integration of software and hardware is more important for tablets and smartphones than it was for the PCs. Apple has always used this approach, which has proven very successful.

An acquisition is by definition anti-competitive, as the number of competitors decreases with 1. In this particular case, it could become an anti-trust issue as Google provides the Android platform to several other producers of smartphones and tablets[xi]. By owning Motorola it will be competing directly with these producers. Google could choose to stop delivering the software or, less aggressively, favor its own hardware, similar to what Microsoft did with Internet Explorer. This way Google could create a monopoly position. Additionally their search engine can favorably show their products, reinforcing this monopoly. At the time of the offer, Google was being investigated by anti-trust authorities for similar actions involving its’ subsidiary, YouTube.

In conclusion, if the synergy between Google and Motorola is exploited, the purchase will enable Google to become a dominant player on the tablet and smartphone market by the vertical integration and economy of scope it stands to create. Google needs remain cautious to not create the impression of being anti-competitive, to avoid litigation and can use Motorola’s patents to settle current litigation issues. For Motorola the merger has specific strategic and competitive advantages. Finally, the merger will allow Google to further pursue its diversification strategy and continue growing.


[i]  Geoff Riley, formerly Head of Economics at Eton College, http://tutor2u.net/economics/content/diagrams/mes.gif
[ii] LE Yelle - Decision Sciences, 1979 - Wiley Online Library
[iii] LE Yelle - Decision Sciences, 1979 - Wiley Online Library
[iv] Portfolio selection: efficient diversification of investments, H. Markowitz, ISBN 0-300-01369-8
[v] The Economist – Schumpeter - http://www.economist.com/blogs/schumpeter/2011/08/googles-purchase-motorola-mobility
[vi] Martynova, Marina and Renneboog, Luc, Mergers and Acquisitions in Europe (January 2006). ECGI - Finance Working Paper No. 114/2006; CentER Discussion Paper Series No. 2006-06. Available at SSRN: http://ssrn.com/abstract=880379
[vii] D. Begg and D. Ward, Economics for business, ISBN 978-007712473-1
[viii] Agency Theory: An Assessment and Review,  K. Eisenhardt, The Academy of Management Review, Vol. 14, No. 1, (Jan. 89), pp. 57-74, (http://classwebs.spea.indiana.edu/kenricha/Oxford/Archives/Oxford%202006/Courses/Governance/Articles/Eisenhardt%20-%20Agency%20Theory.pdf)
[x] The Economist – Schumpeter - http://www.economist.com/blogs/schumpeter/2011/08/googles-purchase-motorola-mobility

Tuesday, November 29, 2011

You're Probably a Micromanager



Recently read this article, which is really enlighting. Give it a try and you may realize that You're Probably a Micromanager!