From the Mailbag: Why Is Vertical Integration Working Today?

One of my readers recently asked a very provocative and interesting question concerning the recent success of certain vertically integrated business models.

The razor/blade post really got me thinking back to something that's been discussed at great length in the media but for which I still have not found an explanation that resonates with me. Apple and Nintendo are both soaring high by tightly integrating hardware, software and services. I understand that this makes for a better user experience, etc., but why is this strategy prevailing so mightily against the 3rd party, modularized strategy that worked so well for MSFT for 2 decades?

I am both a Mac and Wii owner, so clearly I see the advantages of both platforms, but I have a hard time explaining why these strategies work so well on a macro level. Why was the fully integrated strategy such a failure in the 80's and 90's but so dominant today?

Wow, this is a great question. However, I think that my insightful reader is actually raising two separate issues, one relating to vertical integration and one relating to the specific issues facing Microsoft. I do, however, put Apple and Nintendo firmly in the vertical integration camp while Sony and Microsoft are more in-line with a distributed, third-party model. I will spend more time on my theory concerning business models but will comment on the Microsoft-specific question at the end of the post.

For purposes of clarity, Wikipedia describes vertical integration as follows:

In microeconomics and managing management, the term vertical integration describes a style of ownership and control. The degree to which a firm owns its upstream suppliers and its downstream buyers determines how vertically integrated it is. Vertically integrated companies are united through a hierarchy and share a common owner. Usually each member of the hierarchy produces a different product or service, and the products combine to satisfy a common need...

One of the earliest, largest and most famous examples of vertical integration was the Carnegie Steel company. The company controlled not only the mills where the steel was manufactured, but also the mines where the iron ore was extracted, the coal mines that supplied the coal, the ships that transported the iron ore and the railroads that transported the coal to the factory, the coke ovens where the coal was coked, etc.

So, in addition to Carnegie, consider two of the most famous vertical business models of yesteryear: Ford Motor and U.S. Steel. Vertical integration grew up as a vehicle for controlling every layer of the value stack, when certain of these layers were absolutely vital to completing the finished product and where the ability to dynamically hedge supply inputs simply didn't exist. The best hedge was a perfect hedge, i.e., owning coal mines, iron ore mines, barges and smelters if you needed steel for either girders to sell or cars to manufacture, and anything less was viewed as unacceptable. And this model was clearly right for the times, where the implicit costs of insurance (controlling the entire value stack) were less than the risks and volatility associated with supply chain uncertainty.

However, as expertise became more distributed, the implicit cost of insurance began to rise relative to the risks of a third-party input-sourcing model. Specialists in each layer of the value stack - mining, shipping and steel making - became increasingly efficient, so much so that the cost and quality disadvantage of vertical integration began to  weigh so heavily on the business model that it began to crumble. Further, as it became easier to hedge against supply risk, the reasons for remaining vertically integrated deteriorated even more. And as companies that didn't have the same natural resource advantages as the global market leaders emerged in these industries, i.e., Toyota and Nippon Steel, they were ruthlessly focused on costs, efficiency in the raw-materials-to-finished-goods transformation process and building third-party stability in their supply chains. The result: they were built to win out of necessity, and subsequently kicked the crap out of their fat, lazy and "luckier" competitors. We know how this story played out.

So what of Apple and Nintendo? Why, as my commenter mentioned, do these models succeed when other vertically integrated business models fail? My hypothesis is as follows:

Vertical integration succeeds today because the integration is around IP, not raw materials. The integration of IP "wraps" the value stack, serving as the glue that seamlessly links one process to the next - hardware design, software design, user interface, and the user experience, which is an amalgam of the three. These are not three serial processes but a single integrated unit made up of three components, more akin to a single project than three discrete and independent processes.

If Apple and Nintendo opened their own fabs to control their chip supply, this would be silly. So the vertical integration metaphor is a little different in their case. Sure, they may build their boxes, design their operating system, publish their own software and polish their user experience, but this is different type of vertical model than had previously existed. The value is around starting from the user experience and working backwards, instead of starting with an engineered piece of hardware and then designing software and a user experience to make it work. This is the Sony model. This isn't working so well if the goal is to sell a product with broad market acceptance.

Unless you are close to the market and know what it wants and needs, how can you come up with the right design? It seems that you just can't get the pieces stitched together right in a manner that broadly resonates with the marketplace unless you have tight linkages up and down the value stack, which cries for the type of vertical integration practiced by Nintendo and Apple. I don't think this is a fad; I think it is reflective of a world that is increasingly consumer-driven, as opposed to the world we used to live in where the mantra went kind of like "What GM builds people buy." This mind-set is certain failure in today's marketplace, and one only need look at the road-kill that are companies founded in eras past that got the joke just a little too late. I'm not sure if I have sufficiently answered the business model question but hopefully I've gotten my reader part of the way there.

Concerning Microsoft, I think its model could be successful if it could transition its culture from one that is painfully desktop-centric to one that is user-centric. Desktop applications are simply not going to be the engines of the future. It doesn't mean that Microsoft won't spin off billions of cash for a long time. But so do productive oil wells. But these are decaying assets, ones for which significant future growth is an impossibility but high present-day cash flows are a certainty. Does this describe Microsoft? Unless it figures out how to transform itself, yes. So don't confuse its cash balance for growth. Real growth, sustainable growth will be a function of leveraging its prodigious IP into more online, user-friendly applications. It could be business. It could be consumer. But it has to be lighter and friendlier, it has to  be open and it has to work. Just my two cents.

Business model is key, no question. And in the case of Apple and Nintendo, a blast from the past - vertical integration - is just the ticket to rapid growth and happy customers.