The Return of Vertical Integration
 
A century ago, the titans of industry - Ford Motor Company, U.S. Steel, Standard Oil, and others - strove to secure competitive advantage by controlling both the means of production and the path to market.

This strategy made perfect sense. At a time of rapid growth in demand for their products, a company like Ford couldn’t take the risk that its primary supplier of rubber would double its prices overnight. It couldn’t take the chance that the supply of metal it needed for automobile bodies would be available if key suppliers slowed production or went bankrupt. Neither could it expose itself to the possibility that a competitor would outbid Ford for access to railcars hauling raw materials to Detroit and finished automobiles to the rest of the country.

So like the other giants of the Mass Production Era, Ford secured the resources it needed by controlling everything it needed to build a vehicle. The company owned rubber plantations, iron ore mines, and railways?of course, it already owned the sprawling factories where its cars rolled off the assembly lines.

But as Ken Favaro of the consulting firm Strategy& noted recently in Strategy+Business, “[V]ertical integration largely fell out of favor when conglomerations became fashionable during the late 1960s and early ’70s. In fact, many industries underwent vertical disintegration. Today, for example, almost three-quarters of the parts going into American cars are sourced from outside the United States.”1

In the early years of the Digital Revolution, new technologies and the rise of globalization enabled the splintering of the value chain. Companies could collaborate with partners around the world. Low-cost manufacturing, particularly in China, made it foolish for U.S. companies to pay union factory workers high multiples of the cost of outsourcing production overseas.

Moreover, the most influential management advice, such as C.K. Prahalad and Gary Hamel’s 1990 Harvard Business Review article, “The Core Competence of the Corporation,” advocated that businesses “stick to their knitting” by focusing on what they do best and outsourcing all the rest.2 The most famous example of a company that followed this approach is Nike, which focused on designing athletic shoes and apparel and marketing its brand, while outsourcing the actual production of its products to outside vendors.

Similarly, in industries like software and energy, companies now focus on specific stages in the value chain rather than trying to own all of it. For example, in the oil business, some companies concentrate on finding oil, others on extracting it, others on refining it, and still others on selling it to consumers at the gas station.

But now, vertical integration is once again becoming a powerful business strategy, under a new name: the “full stack” business model.

In fact, many of the most innovative and successful companies today are already using or migrating toward the full stack strategy:3

- Netflix and Amazon are creating their own content rather than licensing existing television series from television networks.

- Harry’s, a company that sells men’s razors online using a subscription model, recently bought a German factory to manufacture its own blades.

- Apple and Disney operate their own stores dedicated exclusively to their own brands.

- Tesla is following Ford’s approach from 100 years ago by sourcing the batteries for its electric cars from its own plant, while selling the cars directly to consumers and providing them with free electricity via its Supercharger recharging stations.

- Starbucks purchases its own coffee from growers, roasts the coffee, and sells it through company-owned stores.

- Warby Parker, the eyeglass startup that uses a full stack model to control every aspect of the buyer experience (and sell fashionable frames for a fraction of the price charged by competitors) is raking in more than $100 million in annual revenues and was named #1 on Fast Company’s list of the fifty most innovative companies for 2015.4

In each case, the company is able to control its costs by owning the entire value chain. It also can control the consumer’s perception of the product by ensuring that it is displayed, supported, and priced in a way that benefits the brand rather than a third-party retailer.

Based on this trend, we offer the following forecasts:

First, the full stack approach will make sense for companies that meet two conditions.

According to Favaro, the first of these two conditions is the existence of a “market failure” that threatens your business, such as supply risk, demand risk, or profit gouging. The second condition is the ability to overcome that market failure.5 As Favaro notes, “Without market failure, vertical integration is just plain ole diversification. And without the power or capabilities to exploit a market failure, it’s a very risky strategy.” For example, Netflix’s foray into original programming with such shows as House of Cards reflects the economics of the entertainment industry. Due to profit gouging by producers, it is far cheaper for Netflix to develop its own shows than it is to license shows from a network.

Second, companies pursuing vertical integration will unleash a boom in mergers and acquisitions.

Rather than taking years to develop a needed capability or a source of supply, businesses seeking to dominate their markets will make strategic acquisitions. For example, the Ferrero chocolate company acquired the leading processor of hazelnuts, which is the key ingredient in Ferrero’s Nutella hazelnut spread. Delta Airlines recently acquired an oil refinery in order to stabilize its supply of jet fuel. In both cases, the companies preempted the possibility of a disruption in the supply chain that could either ground their business or elevate costs beyond what consumers would be willing to pay. For the same reasons, some analysts believe that the only way Whole Foods will be able survive in the face of stiff competition in the natural foods market is to produce its own organic foods.6

Third, as companies expand into other parts of their value chains to pursue a full stack strategy, entire industries will be disrupted.

Consider the rumored move by Amazon into developing its own global transportation and delivery network. As reported in the trade journal DC Velocity, which covers logistics and supply chain management, Amazon will introduce its own shipping network before the end of 2016.7 For consumers, the result will be guaranteed delivery in two hours or less. For established delivery services like FedEx and UPS, losing Amazon’s business would truly be catastrophic. As for Amazon, creating its own delivery service would add another service, like its successful cloud computing offering, that it could sell to other companies. According to Colin Sebastian of Baird, as cited on Investorplace.com, this could represent up to a $450 billion opportunity for Amazon.

References

1. Strategy+Business, Autumn, 2015, “Vertical Integration 2.0: An Old Strategy Makes a Comeback,” by Ken Favaro. ⓒ 2015 PwC. All rights reserved.

http://www.strategy-business.com/blog/Vertical-Integration-2-0-An-Old-Strategy-Makes-a-Comeback

2. Harvard Business Review, May?June 1990, “The Core Competence of the Corporation,” by C.K. Prahalad and Gary Hamel. ⓒ 1990 Harvard Business School Publishing. All rights reserved.

https://hbr.org/1990/05/the-core-competence-of-the-corporation

3. Strategy+Business, Autumn 2015, “Vertical Integration 2.0: An Old Strategy Makes a Comeback,” by Ken Favaro. ⓒ 2015 PwC. All rights reserved.

http://www.strategy-business.com/blog/Vertical-Integration-2-0-An-Old-Strategy-Makes-a-Comeback

4. For more insight into Warby Parker, visit the FastCompany website at:

http://www.fastcompany.com/3041334/most-innovative-companies-2015/warby-parker-sees-the-future-of-retail

5. Strategy+Business, Autumn 2015, “Vertical Integration 2.0: An Old Strategy Makes a Comeback,” by Ken Favaro. ⓒ 2015 PwC. All rights reserved.

http://www.strategy-business.com/blog/Vertical-Integration-2-0-An-Old-Strategy-Makes-a-Comeback

6. Seeking Alpha, September 1, 2015, “For Whole Foods Market, Vertical Integration May Become Its Whole Point of Sale,” by Jay Wei.   2015 Seeking Alpha. All rights reserved.

http://seekingalpha.com/article/3480796-for-whole-foods-market-vertical-integration-may-become-its-whole-point-of-sale

7. DC Velocity, October 21, 2015, “Amazon Assembling Executive Team to Support Rollout of Shipping Network,” by Mark B. Solomon. ⓒ DC Velocity, a publication of Agile Business Media LLC. All rights reserved.

http://www.dcvelocity.com/print/article/20151021-amazon-assembling-executive-team-to-support-rollout-of-shipping-network/