Vertical Integration in a Rapid World

I have long been a student of organizational structure. In general, I've been a proponent of specialization and laser focus. This works against the concept of conglomerates specifically and vertically-organized enterprises generally. A recent Wall Street Journal article highlighting several recent examples of vertical integration piqued my interest. Just why is it that vertical integration seems more compelling today than it did even five or ten years ago? What has changed in the environment to have caused the perceptions of many to do a 180? Is this a rational adaptation to a different landscape or a costly fad that will invariably run its course?

Vertical integration has often been linked with monopolists seeking to exercise control over a particular product or market, e.g., Andrew Carnegie and steel in the 1850s, Henry Ford and automobiles in the 1900s. From mining operations to refineries to ships and rails to factories and distribution, these companies controlled every part of the their supply chain. They overpowered their supply chains with capital, and barriers to entry were high. Starting a new steel company was no mean feat, and competing against Henry Ford wasn't a picnic, either. But over time, as these industries globalized, the value of each part of the supply chain shifted. Japan became a powerhouse in steel from a processing perspective, creating high-quality steel with few defects at low cost. But they didn't have control over the raw materials supply chain. Technology and quality management became the key sources of differentiation, and the US steel companies that were slow to adapt got crushed. A similar phenomenon happened with the Japanese and the auto industry, where they didn't control the bottom layers of the value stack but used technology, process engineering and customer focus as sources of competitive advantage. In the face of superior technology and control processes, the power of vertical integration withered.

Fast forward to today. We're seeing several examples of the return to verticalization, including those cited in the WSJ article: Oracle, Boeing, HP, and Apple. The general knock I've had against these kinds of moves is that a company has a core competency, and when it strays from that competency it sub-optimizes. For example, can a company really design and manufacture the best hardware AND software? Can it design and manufacture the best printers, communications equipment AND run a world-class consulting business? Wouldn't it be better to put all of one's efforts into a particular area, achieve market dominance and high profit margins, and dividend the cash out to shareholders rather than spending it on acquisitions to achieve vertical dominance? Certainly over the last 30-40 years the pendulum had swung towards specialization, as the vertically integrated companies got picked apart up and down the value stack: there were always companies better, stronger, faster than members of a vertical organization. But something has changed. In a word: speed.

The world has flattened. Supply chains are global and fragmented. Information dissemination happens at lightening speed. Customer preferences drive design and not the other way around. Think about the impact Apple has had by controlling the user experience, a seamless integration of hardware and software. This is markedly different than the Dell/Microsoft/Intel experience. Apple is selling not just a product but an experience, an image. Dell is selling a bundle of features. And Apple is able to achieve this partly because of vertical control of its value stack. Dell is a procurer and an assembler. And they are very good at it. But Apple's tight integration laid the foundation for a host of add-on hardware and software solutions that augment the core experience. Dell simply can't go to these places because it lacks the holistic perspective and control. Assuming perfect access to all materials in its supply chain, might Apple be able to deliver its customer experience better and more cheaply by simply focusing on software and product design than it does today? Sure. But given that perfect access doesn't exist and that speed is critically important to adapting to changing customer preferences, does vertical integration create a kind of option value that a more fragmented supply chain lacks? Undoubtedly.

Historically specialization has conveyed perceived option value, where the best suppliers can be tapped at all times and with weaker suppliers being replaced in the name of ruthless efficiency. But I believe option values have flip-flopped. Specialization may, in fact, represent a short option position, as scarce resources can be parceled out by sharp suppliers to the highest bidder, while those with vertical control can respond and react in real-time to changes in market conditions. Might the pendulum swing back in the other direction? It always does. But might vertical integration be in vogue - and the rational and adaptive approach to best serving customers and maximizing profits - for the next few decades? I'd say so. And I have to admit I never thought I'd say that...