Eventually everything comes back into fashion. It’s been true for bell bottom jeans and according to the Wall Street Journal, business strategies (Companies More Prone to Go ‘Vertical’, Nov 30). Specifically, the Journal claims that vertical integration — a firm owning multiple levels of its supply chain — is making a come back.
“The pendulum has shifted from disintegration to integration,” says Harold Sirkin, global head of the Boston Consulting Group’s operations practice. He attributes the change to volatile commodity prices, financial pressures at suppliers and quests for new revenue — challenges exacerbated by the recession.
Just two years ago, for example, [CEO Larry] Ellison said Oracle would stick to its traditional focus on software. Computer hardware isn’t “a business we have any ambitions in,” he said then. In a September speech, he called that view “fundamentally wrong.” Mr. Ellison declined to comment for this article.
The moves toward vertical integration are a departure from the past half-century, when companies increasingly specialized, shifting functions like manufacturing and procuring raw materials to others. Steelmakers in the 1980s sold their mining operations; in the 1990s, auto giants spun off their parts suppliers. Tech companies stopped making every piece of a computer system and specialized in chips, data storage or software.
To bolster its point, the article identifies a number of recent deals:
This is an interesting argument. Vertical integration has had a bad wrap for some time but it is not clear that this a cut and dry change of heart as opposed to those with cash taking advantage of a depressed economy to do a little bargain hunting or to place strategic bets. Take the GM example above. In 1999, GM floated its parts division Delphi off as a separate company. Now GM has bought back a few Delphi factories. Did GM really have an aversion to making parts in house a decade ago and now changed its mind? A more accurate statement may be that GM didn’t like dealing with the UAW at its parts plants who had a contractual right to fight to keep a part in house. That is, GM may well have been OK making its own parts if management could have complete control over what they did in house and what was sourced from the outside.
So why has GM changed its mind? Is it feeling flush with taxpayer cash? Well, as we have posted on before, parts suppliers as a whole are not in great shape. Delphi is no different. They have been Chapter 11 for the last several years. Further, Automotive News reports that some auto suppliers are now playing hard ball through the bankruptcy process (Suppliers’ customers cry foul over ‘surprise’ bankruptcy tactic, Nov 30). Apparently a few firms have forced “customers to the negotiating table to work out new long-term supply agreements as a condition to continue receiving parts in the short term.” If GM can buy the factories from Delphi at a reasonable price, why not skip the hassle?
The Journal article basically admits that this time vertical integration is a little different:
“The historical view of vertical integration was that you had complete control of the supply chain and that you could manage it the best,” says Bain & Co. consultant Mark Gottfredson. Today’s approach is more nuanced. Companies are buying key parts of their supply chains, but most don’t want end-to-end control.
What I find particularly interesting are deals aimed at controlling some aspect of raw materials. I wonder how much of this is an over-reaction to volitile commodity prices before the global economy collapsed or whether the Malthusians will finally be right and we are headed for an era of extreme resource scarcity. One example of this is Tiffany’s getting into mining and diamond polishing that we have posted about before. Another luxury goods firm, Hermès, has apparently been buying tanneries that specialize in alligator hides and now dominates that market (As Sales Vanish, Skins Stay on Alligators, New York Times, Nov 29). Some would say that they are up to no good:
Hermès bought aggressively from the farmers, and is still buying, though recently at prices far lower than in the past and lower even than the price of raising an alligator. All of this could be attributed to a very bad market. Luxury watch sales, on which the farmers are hugely dependent, are off by as much as 25 percent. But farmers look at the situation and say something does not add up.
While the tanneries are offering farmers little for their raw product, citing the recession, fashion houses are complaining about the astronomical prices for tanned hides. Many labels are giving up and moving away from alligator altogether, and well-known luxury brands like Manolo Blahnik say it is increasingly difficult to make a profit on such an expensive product.
Before leaving this topic, it should be noted that today’s Journal had another article that described a firm a different approach to these challenges. Vertical integration may not be needed if one can work closely enough with suppliers. The firm in this case is Sharp (Sharp’s New Plant Reinvents Japan Manufacturing Model, Nov 30). Sharp has opened a new plant in Japan to produce liquid-crystal display panels. This is not an ordinary plant; it cost in the ball park of $11 billion and supposedly could accommodate 32 baseball stadiums. (Why the size is measured relative to a nonuniform sized athletic facility as opposed to a standard sized football field is not explained.) This obviously is a significant investment even for a large firm like Sharp. And it is cuts against the industry norm. Most players in the industry are moving toward relatively low-tech solutions in low-wage countries. Japan has relatively expensive labor so Sharp must rely on advanced technology to compete.
However, it is not going it alone.
Sharp aims to streamline the costly LCD-panel production process by moving 17 outside suppliers and service providers inside its factory walls to work as “one virtual company.” In the past, Sharp kept suppliers within driving distance. Supplies are sent not by truck from a nearby factory but by automated trolleys snaking from one building to another. The suppliers, which include Asahi Glass Co. and Dai Nippon Printing Co., built and paid for their own facilities and are renting the land from Sharp. Despite their location inside the plant, Sharp says its suppliers are permitted to sell their products to other companies. At Sakai, Sharp has also linked its computer systems with suppliers so an order to the factory alerts suppliers right away. In the past, Sharp would email or call suppliers and place orders, creating a longer lag time. Sharp wouldn’t disclose how much, if any, cost savings will result from manufacturing LCD panels at Sakai, but analysts estimate a 5% to 10% savings.
This is obviously not the same as vertical integration. It is also not completely a novel approach. Many auto companies have played with similar schemes. Check out this video of a Ford plant in Brazil at which supplier employees work in the same building as Ford’s:
Given that such tight integration is now possible across companies one wonders whether the Journal is giving into hyperbole.