High-Flying Companies Resurrect Vertical Integration Strategy

Some of today’s most highly successful and innovative companies have resurrected an older strategic paradigm — vertical integration — and have transformed it into the formula for their strategic growth.

In the December 2020 issue of ENTREPRENEUR, Leonard Sherman, the magazine’s executive in residence and adjunct professor at Columbia Business School, developed an article entitled, “What Makes Peleton, Apple, Netflix and Tesla Successful?”  He writes:

“Peloton announced blowout earnings last week, and has joined an elite club that includes Apple, Netflix and Tesla. These companies not only delight their customers and create enormous shareholder value, but they also operate a highly vertically integrated enterprise. The success of these companies is rewriting some outdated rules on what drives effective business strategy.”

He goes on to trace the old theory of vertical integration, which had come to mean “the ownership of all facets of a company’s supply chain.” For example, Shell Oil comes from wells owned by Shell, transported by Shell pipelines to the Shell refineries, and then delivered to Shell service stations.

In the last half century, vertical integration has been replaced by a “capabilities- driven strategy showcased by Walmart.”  According to Sherman, “…through the lens of capability-driven strategy, Walmart exploited its expertise in global sourcing and supply chain management to build a formidable competitive advantage in wide product selection at everyday low prices.”

Sherman adds that Bain consultants Chris Zook and James Allen turned this vertical integration concept into “conventional wisdom.”  When Apple started opening its own stores, Bloomberg published what Sherman describes as a “spectacularly misguided” commentary entitled “Sorry Steve (Jobs), Here’s Why Apple Stores Won’t Work.”

As it turned out, Apple’s company-owned retail operation has become spectacularly successful thanks to its blockbuster iPhone.  Knowledge at Wharton (March 16, 2012) highlights Apple’s long-time commitment to vertical integration: “Apple, for 35 years, has championed a vertical model, which features an integrated hardware and software approach. For instance, the iPhone and iPad have hardware and software designed by Apple, which also designed its own processors for its devices.”

While the Apple vertical integration model is part of its DNA, the Peloton model is a less obvious success story. Sherman writes: “In 2011, John Foley conjured up an idea for a “connected fitness” company that would ultimately require expertise in hardware design, software development, professional video production, fitness studio operations, and physical retailing, none of which matched the founder’s professional background.”

Foley’s initial plan was to fit Peloton’s own software and electronics to existing bicycle and tablet computers. This enabled the ability to monitor real-time rider performance and stream online spin classes. Foley and his co-founders decided it would be best for Peloton to develop its own products and internal capabilities instead of using third-party providers.

Sherman identifies three situations in which the vertical integration model can work well:

1. Does owning or controlling assets and capabilities across the value chain significantly improve product performance and customer experiences? For companies like Apple, Netflix, Tesla, IKEA, Allbirds, and Peloton, vertical integration has proven to be a key driver of superior company performance while also building barriers to competition.
2. Can the requirements for capability-building capital be scaled to reflect a company’s stage of development? Even though start-ups are often cash poor, they can develop capabilities in small ways.  “For example, Peloton tiptoed into retailing, streaming video classes, and white-glove bicycle delivery with small pilot operations in a single metropolitan area before expanding the scope of its operations internationally,” writes Sherman, pointing out that when IKEA decided to make its big expansion, “it faced nine-figure investments to build fulfillment centers, webstore infrastructure and new operating processes across its multinational operations prior to launch.”
3. Are the products and services offered conducive to generating premium returns from superior product performance and customer satisfaction? The required investments in vertical integration can only be justified if enough consumers recognize and are willing to pay premium prices for superior performance.

Columbia University Professor Rita McGrath, in the Dec. 2, 2009 Harvard Business Review (“Why Vertical Integration is Making a Comeback”), writes: “Vertical integration makes complete sense for a company that innovates by dramatically changing the customer’s experience. Why? Because a customer-experience-innovation strategy depends on creating experiences that are easy, seamless, affordable, and, if possible, more pleasant than alternatives.”