When pursuing a vertical integration strategy, a firm gets involved in new portions of the value chain. This approach can be very attractive when a firm’s suppliers or buyers have too much power over the firm and are becoming increasingly profitable at the firm’s expense. By entering the domain of a supplier or a buyer, executives can reduce or eliminate the leverage that the supplier or buyer has over the firm. Considering vertical integration alongside Porter’s five forces model highlights that such moves can create greater profit potential. Firms can pursue vertical integration on their own, such as when Apple opened stores bearing its brand, or through a merger or acquisition, such as when eBay purchased PayPal.
Example 7.5 Vertical Integration
Vertical integration is the future of streaming services such as Spotify. While Spotify is primarily a music streaming service, they learn the value of creating and distributing original, organic content to compete effectively in the steaming content market. Their current operating model that puts them in the middle between creators and consumers puts Spotify in a precarious position where music labels extract about 75% of Spotify’s revenue annually. Following Netflix’s model of vertical integration, is widely considered the most effective way to remain relevant in today’s ever changing streaming industry.
Source: Quartz, Dan Kopf, Why Spotify wants to be like Netflix now, Aaron N Wager, 2019Wi
Today, oil companies are among the most vertically integrated firms. Firms such as ExxonMobil and ConocoPhillips can be involved in all stages of the value chain including crude oil exploration, drilling for oil, shipping oil to refineries, refining crude oil into products such as gasoline, distributing fuel to gas stations, and operating gas stations.
Vertical integration also creates risks. Venturing into new portions of the value chain can take a firm into very different businesses. A lumberyard that started building houses, for example, would find that the skills it developed in the lumber business have very limited value to home construction. Such a firm would be better off selling just lumber to contractors.
Example 7.6 Safety through Vertical Integration
Seven & i Holdings Co., 7-Eleven’s mother company is considering acquiring Speedway gas stations from Marathon Petroleum Corp. for $2 billion in an effort to protect its convenience store market. Convenience stores and gas stations are strongly linked. Meanwhile, electric vehicles are becoming increasingly popular. Creating an electric charging infrastructure is a major problem facing the gas market since the price of electric vehicles has been falling. Vertical integration through combining convenience food and gasoline is now being threatened and Seven & i wants to transform its outlets to compete with more conventional charging in homes and workplaces.
Source: Bloomberg, David Fickling, The Gas Station M&A Frenzy Looks Like a Bubble, Siyuan Wang, 2020Sp
Vertical integration can also create complacency. For example, a situation in which an aluminum company is purchased by a can company. People within the aluminum company may believe that they do not need to worry about doing a good job because the can company is guaranteed to use their products. Some companies try to avoid this problem by forcing their subsidiary to compete with outside suppliers, but this undermines the reason for purchasing the subsidiary in the first place.
A backward vertical integration strategy involves a firm moving back along the value chain and entering a supplier’s business. Some firms use this strategy when executives are concerned that a supplier has too much power over their firm. In the early days of the automobile business, Ford Motor Company created subsidiaries that provided key inputs to vehicles such as rubber, glass, and metal. This approach ensured that Ford would not be hurt by suppliers holding out for higher prices or providing materials of inferior quality.
A forward vertical integration strategy involves a firm moving further down the value chain to enter a buyer’s business. Disney has pursued forward vertical integration by operating more than three hundred retail stores that sell merchandise based on Disney’s characters and movies. This allows Disney to capture profits that would otherwise be enjoyed by another store. Each time a Hannah Montana book bag is sold through a Disney store, the firm makes more profit than it would if the same book bag were sold by a retailer such as Target.