Sunday, October 8, 2017

Vertical Integration is Risky, But Might be Imperative

Vertical integration now is becoming an important strategic issue in the applications and communications industries, welcome trend or not.

Whether or not most mobile and fixed communications operators are able to move up the stack,  Google is clearly moving down the stack into devices, retail internet access, undersea capacity and new access platforms. It is not alone.

Amazon’s purchase of Whole Foods, the grocery store, moves Amazon elsewhere in the distribution chain.

Amazon’s creation of its own air freight operation, and now its moves into retail package delivery provide other examples of app layer integrating backwards into the value chain.

And Amazon long ago got into the devices business (KIndles, Echos, phones, tablets).

In the video entertainment business, content networks and owners are moving to integrate content distribution platforms to go direct to consumers as well.

Apple designs its own integrated circuits.

As always, the point of such vertical integration is to capture business benefit. "Vertical integration is simply a means of coordinating the different stages of an industry chain when bilateral trading is not beneficial,” say McKinsey consultants.

Generally speaking, value chains that feature adjacencies where there are few sellers and few buyers create business risk.

Reliance on a single, or a few customers, is a source of business risk because of the implications of losing those few customers, or having them significantly reduce buying volume. Likewise, reliance on a single, or just a few products, creates similar risk.

For Google, internalizing undersea capacity assets simply saves it money, while providing better quality control and flexibility. Amazon finds the same motivations drive its creation of air freight and local delivery services.

For Google, creating its own devices supplies the same value as does Apple in tightly integrating software and hardware. On the other hand, intervening in the internet access markets causes all the traditional suppliers to upgrade the existing access infrastructure.

Few firms arguably succeed at vertical integration. But successful moves can create barriers to market entry by other firms. And that is why vertical integration matters.

AT&T believes it can, and likely must, vertically integrate. At the moment, its moves to become a content producer and owner are the most-obvious example. In the future, moves to integrate various internet of things applications, services and platforms are likely to be equally important.

Simply put, the mobile services business model has reached saturation in the U.S. market, and firms such as AT&T must find entirely new services to sell to its customers.

You would be correct in arguing that such vertical integration is highly risky, and that horizontal acquisitions make more sense for most firms, when possible. The problem is that horizontal growth sometimes is difficult to impossible.

In its home market, horizontal expansion is not possible for AT&T, for regulatory reasons. Horizontal expansion is possible internationally, but will not help decline in its core market, absent some significant vertical movement.  

For other firms, such horizontal acquisitions take lots of capital, and that generally means additional debt. That can be difficult in a business that normally requires fairly high levels of debt, in any case.

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