Vertical Integration is Hot Again, With a Twist

Vertical integration just got hot again.

With Microsoft’s recent launch of the Surface Studio, Google’s announcement that it is going to make its own phones with Pixel, and now Samsung’s widely rumoured push into software with the introduction of its own AI, there has been another definitive shift in the way all of the largest technology companies approach their operational strategy.

It’s a move towards a more vertically integrated strategy, though it’s not quite that simple. There’s a 2.0 twist, but more on that below.

An evolution 20-years in the making

Apple has long taken this approach, and for some (including Steve Jobs himself), it’s the reason why it managed to take the dominant market-leading position that it did after his return.

Ditto Amazon, which many people see as much as a logistics company as an eCommerce one. They’re now even dipping their toes into physical retail stores possibly with an eye to controlling that experience too, much like Apple do.

We’ve seen it with the evolution of Netflix and Amazon Video, where they’re not just the distributors of content, they’re also the commissioners and creators too.

The proposed AT&T and Time Warner merger would take this a step further again, bringing under one roof the entire value chain from wires and infrastructure, to content creation to distribution. (In that particular case, just about all expert commentary seems to agree there’s no actual benefit in going this far.)

But a vertically integrated approach hasn’t always been as popular in tech business models as it currently is.

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Netflix is a modern example of backward vertical integration, as it has gone upstream to secure its future.

The benefits of a distributed operating model

A competing approach was perhaps best typified by Microsoft in the late 90s.

Though Apple is currently still the most valuable company in the world, for a long time Microsoft kicked its hipster-focused ass in terms of revenues and stock value.

In fact Microsoft’s distributed business model was very much a factor in it reaching such a massive size and scale, making Bill Gates the world’s richest man in the process.

Why distributed models make a lot of sense

You get to focus on one core competency, and let partners focus on theirs. For many internet companies, it made most sense to focus on software – the brains that went into the hardware – and do it really well.

You get more rapid distribution. By not having to worry directly about how to get units into the hands of consumers, and spreading that go-to-market strategy amongst multiple consumer-facing brands with established distribution channels and retail relationships, it means you can ship your software much faster and wider than trying to start from scratch.

You mitigate your risk and exposure, and it’s much more resource efficient. By not having to handle large supply chains, balance stock and run all the global logistics required to get hardware to market, it hugely reduces your exposure to fluctuations in market demand, while making you a more efficient business (which stock markets love).

Faster response to market demand. Vertically integrated businesses often find it harder to respond quickly to changes in demand, because their entire business model has to shift from top to bottom, whereas more distributed businesses can be more agile, finding new partners, suppliers, distributors etc. to work with, who are more aligned to the new demands of the market.

A good look up and down (the value chain)

So why the shift towards a more vertically integrated model of business? There are four main reasons.

1. Underwhelming partners

The major problem with a distributed model is: what happens when your hardware partners just aren’t good enough?

For example, after years and years of OEMs producing humdrum PCs that have led to tanking sales for the market as a whole, Microsoft obviously felt they had to take their destiny into their own hands. Ditto with Google, and its move into mobile phone production.

2. They’re still platforms

The beauty of a move back towards vertical integration, is that the likes of Google and Microsoft are able to have their cake and eat it too.

This is because they’ve a) built up such a dominant software position that many OEMs will need to continue working with them, even though they’re now directly competitive.

And b) they also have strong ecosystems and ‘functional integration’ at play, with lots of apps and developers to work with, helping bring diversity and ‘complements’, which also strengthen their position.

Not only that, but because of the complexity of these value chains for modern tech, they still choose to work with best-in-class suppliers where it makes sense to as well.

For example Netflix produces its own content, but also licenses content from studios and networks where it still makes economic sense to do so; and Google will still work with specialists in microprocessors and chip components to power core aspects of its Pixel phones.

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Google has moved towards a vertical integration model with its Pixel phones, designed and made by Google.

3. Hardware is a bigger deal

If you think about a lot of hardware from the 2000s, it was pretty commoditised and mostly sold on features like power and memory. However Apple showed the power of bringing unique hardware – beautifully designed and packaged – to market, with the iPod, iPhone and iPad all pretty much creating new categories from scratch.

With hardware being used for more and more advanced applications by consumers as well as businesses, the need to differentiate has really compounded. Not to mention everyone’s now a design critic. No one settles just for functional utility; everyone expects beauty too.

Think about Microsoft’s Dial and the unique features of its interactive Surface screen; or the advanced AI that will be plumbed into Google’s Pixel phone (and now Samsung’s Galaxy 8 thanks to its acquisition of Viv).

With VR and AR on the cusp of mainstream adoption, the need to own hardware is even more critical.

4. The distance to consumer has shrunk

Last but not least, the comfort with which we purchase goods directly from brands online has continued to disintermediate the traditional distribution channels that would have been essential to a software company’s ability to get their product into the hands of consumers.

Now they can sell it direct, on their terms. Even Tesla, a car manufacturer, is able to shun the traditional model of distributing its cars through dealerships and sells direct to the consumer.

This closeness to consumers – and consumer demand – also helps to lessen the chances of a negative Bullwhip Effect on a vertically integrated technology company, which has historically been a drawback of vertical integration for large manufacturers (including automotive companies).

While not traditionally a tech company, Zara’s advanced, integrated supply chain allows for incredible agility in responding to fashion trends, allowing it to get new ‘on trend’ clothes into its stores in as little as two weeks, an unprecedented achievement in the traditional approach to fashion and retail.

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Tesla is an example of modern vertical integration.

Experience Integration: a winning model

Given the above, it’s pretty obvious that tech companies haven’t really adopted the classic kind of vertical integration favoured by the oil and gas industry during the 70s.

So what model are the world’s most successful corporations now adopting?

With elements of vertical integration more strongly present than in the past, but horizontal/distributed and functional aspects also at work, what common traits tie them together into a coherent operational strategy?

There are 4 consistent elements to their approach.

Project management. Leading tech companies are really made up of a large number of semi-autonomous teams that lead enormously complex projects built on the shoulders of very smart specialists. They take a flexible approach to how those projects are delivered, working with in-house teams and specialist suppliers according to their needs.

Brand coherence. What ties these projects together is a certain level of brand coherence, where users can expect a similar product experience across platforms and devices, tweaked just slightly to take advantage of the inherent advantages (or limitations) of each platform or device. This consistency of experience builds loyalty.

Quality assurance. This is a necessary pillar of creating a good user experience across their entire brand, and is of course key to building and maintaining trust, a prerequisite to loyalty.

Emphasis on design and the user experience. What really sets this new model apart is its relentless focus on the user experience across the value chain, from how components will make the end product perform, to how users purchase and unpack the product, and not to mention how it looks and feels in their hands. This is what breeds fandom and differentiated business value.

And so I would sum up this new operational model as being one of Experience-Led Integration or just Experience Integration.

The world’s most successful corporations have moved to a model of experience-led integration

Todays technology giants are competing with one another by offering an integrated vision inside and out, and delivering it by exerting control over all the key consumer touch-points (particularly design), while operating with a flexible attitude towards working with 3rd parties when it makes sense to do so.

A good model for smaller companies?

So how should other, smaller businesses and start-ups react to this shifting strategy?

Firstly, it still makes sense to start off as a specialist at one point in the value chain. Starting out with a distributed model is far less capital intensive, and less risky too.

In other words, emulate the journey of these tech giants, not their destination.

Then as you grow, see if it makes sense to move up or downstream based on three factors.

Can you do it cheaper? If it becomes costly to license your supplier’s goods or services, particularly as you scale, it may start to make more economic sense to own the supply yourself, which is why Netflix started to produce its own shows, because licensing content was becoming too expensive.

Can you do it better? As you grow, and attract talent to your team, you may realise you can serve your customers better by moving up or downstream, and with your new talent you’ll have the ability to execute against your vision. After all, you know what your customers want better than anyone else.

Does it create unique value? Finally, if you spot commoditised aspects of the user experience where you think you can really innovate and create significant new value for the consumer, this may be a chance to steal a market-leading position on your competitors.

The biggest lesson

The biggest lesson for any growing business to take away from this shift towards a strategy of Experience-Led Integration, is that above all else, you’re responsible for your brand and the customer experience.

You’re responsible for your brand and the customer experience.

Any aspects of the customer experience that may damage your relationship need to be addressed (and ideally owned) by you.

That is the essence of a winning Integrated Experience strategy.

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