What's the Rationale for the AT&T Acquisition of Time Warner?

This week AT&T announced the acquisition of Time Warner in an $85 billion cash-and-stock deal.  Investors did not exactly dance in the streets.  Why the concern from investors about this acquisition, and what's the possible rationale for this deal?  The proposed deal is an example of vertical integration, marrying a content creator (Time Warner) with a distribution system (AT&T).   When we hear about vertical integration, we should ask:  Why will these two entities create value by working together, AND why must they merge to achieve this value creation?  In other words, why can they not achieve certain synergistic benefits through other types of organizational arrangements (e.g., contracts, licensing, strategic alliance)?   AT&T CEO Randall Stephenson certainly understands why investors and analysts will ask if a merger was necessary to capture certain benefits of cooperation between the two entities.  Here is an excerpt from yesterday's Wall Street Journal:

AT&T’s Mr. Stephenson said owning content would make it easier for the carrier to adapt to various platforms quickly in a way that is time-consuming and difficult when it has to negotiate contracts with content partners. “It’s slow, it’s painful, just the contracting itself takes a lot of time whereas when it’s completely owned, you just move a lot faster,” he said Monday.

He might be right, but has he captured the whole story?   Stephenson essentially is arguing that the transaction costs of using market mechanisms (such as contracts) to work with content partners are very high.  He believes that the costs of such coordination are lower if the two entities are part of the same corporation.  Simply put, he believes you can accomplish coordination more easily and more quickly through managerial mechanisms than through market mechanisms.   Is that right?  Well, anyone with experience managing a large vertically integrated firm will tell you that coordination between business units owned by the same parent company is not always so easy or fast.  Bureaucracy, transfer pricing disputes, silo rivalry, and other problems can make life pretty difficult. Moreover, vertical integration reduces flexibility at times to work with desirable outside partners or to change business models, and it puts you in the awkward position of competing with your own customers.   The regulatory landscape also complicates the deal.  As the Wall Street Journal explains, "Analysts note that many of the attractive aspects of owning content—such as keeping it out of the hands of other distributors or giving it free distribution—would be barred by regulators."

In addition to examining AT&T's rationale, I've been considering the perspective of Time Warner in this deal. Time Warner CEO Jeff Bewkes has spent the past decade dismantling a prior failed attempt at vertical integration at his firm. He broke apart the AOL-Time Warner combination, and he divested Time Warner's cable operations. Why then sell yourself to a distribution company now? (ok, the hefty takeover premium is the obvious financial reason!). In particular, it seems odd given that Time Warner has begun to sell its premium content directly to consumers, bypassing the traditional cable operators (e.g., HBO Now). I understand that the content creators have been worried about millennials cutting the cord. Witness ESPN's shrinking subscriber base - clearly a concern at Disney these days. Time Warner surely faces such concerns with some of its content, though perhaps not with a premium network such as HBO. I'm not sure, though, that selling to AT&T solves this fundamental problem. Do we think that innovative new entertainment industry business models will emerge from such a large complex entity, or is it more likely to occur from newer, more nimble players in the industry?

Vertical Integration at Amazon

The Wall Street Journal reports today that Amazon will be moving aggressively to expand its in-house logistics capabilities.  Here is the lead of the article:

Amazon.com Inc. is taking to the air with a fleet of planes, part of a broader effort to reduce its inflated shipping costs. The Seattle retailer plans to shuttle merchandise around the U.S. using as many as 20 Boeing Co. 767 aircraft it will lease from Air Transport Services Group Inc. News of the deal sent the air-cargo transportation company’s shares soaring as much as 24% on Wednesday.

Does this vertical integration strategy make sense?  Let's start with the first sentence of the Wall Street Journal article.  Will the move reduce costs for Amazon?  One would find it hard to believe that Amazon can move goods around the country more efficiently than UPS and FedEx.  Clearly, they cannot match the efficiency of those established players at the moment.  One does not save money simply by doing something in-house.  Some managers think you save because you eliminate the profit margin earned by the supplier (UPS and FedEx in this case).  However, that is not the case because you must invest heavily in new assets in order to conduct this activity within the firm.  Moreover, you may not be as effective at conducting this activity as your supplier.  Thus, it's not clear that profits will automatically improve.

Why then would they pursue vertical integration?  There may be other valid reasons.  First, they may be trying to offset supplier power in this case. In other words, building an in-house capability gives them negotiating leverage with big players such as UPS and FedEx.   Second, UPS and FedEx may be worried about investing in assets specific to Amazon.   Economists call this situation the "holdup" problem that arises when transaction-specific assets are in place.  If UPS and FedEx invest in assets that are unique to Amazon, they may find themselves in a poor negotiating position vis a vis Amazon.  Thus, Amazon may have to invest in these assets because their partners are reluctant to do so.  Finally, Amazon may make their entire supply chain more efficient through closer integration of their ordering, fulfillment, and delivery services.   Conducting delivery in-house may enable that closer integration and perhaps some resulting efficiency.   

In the end, it will be interesting to see how the vertical integration strategy plays out.  Once again, though, Amazon will have more latitude than most publicly traded companies, because investors have proven to be quite patient with them.   Most publicly traded firms would have a hard time justifying this type of vertical integration strategy, which may take some time to pay off.  Amazon will likely have the time to develop this strategy and realize the efficiency gains over time.  

Netflix, Analytics, and Original Programming

Many former and current students have asked me about Netflix's decision to offer original programming.  They always want to know, "Does vertical integration make sense for Netflix or not?"  They know that vertical integration has not always worked out in entertainment industry (think the breakup of Viacom/CBS and the unfortunate consequences of the AOL-Time Warner merger).  I ran across this CNBC interview with Netflix CEO Reed Hastings today (thank you, Professor Jay Rao, for pointing me in this direction!).   Hastings commented on the company's original programming:

Hastings attributed the success of original programming such as "Orange is the New Black" and "House of Cards" to Netflix's powerful data analytics.  "We are just a learning machine. Every time we put out a new show, we are analyzing it, figuring out what worked and what didn't so we get better next time," Hastings added.

Hastings' comments suggest that vertical integration may make a great deal of sense in this case, because Netflix can increase the odds of success with its original programming due to data analytics.  How powerful can data be in this case?  Well, if think about it, Netflix has been invested in "big data" since its inception in the late 1990s (long before big data became a common term).   From the beginning, Netflix did not want to focus on new releases. It wanted to be able to offer a deep library, and then use data to recommend lesser known titles to people.  Now, it's taking that data analytics to a whole new level, by using information it has compiled for over fifteen years to develop original programming.  As we all know, the failure rate for new shows can be quite high.   If Netflix can reduce that rate, even just by a small margin, it can improve the economics of programming substantially.  

Fox, Time Warner, and the Perils of Vertical Integration

The news broke this week about a possible Fox takeover of Time Warner.   As you read these reports, you may have noticed many of the key arguments for why this deal would make sense, i.e. powerful synergies exist between the two media/entertainment companies.  However, yesterday's Wall Street Journal featured a terrific article examining the perils of vertical integration with respect to this  deal.   Note that Time Warner is a major producer of television shows, which it sells to various broadcast networks.    Fox, of course, owns a major television network (and a variety of cable channels).  Warner Brothers is one of the only major TV studios not connected to a major broadcast network (Sony is another).  In the article,  Time Warner CEO Jeff Bewkes says, " Being the leading independent supplier to all the broadcast networks makes us the preferred home to the top writers and producers on TV which, in turn, makes us indispensable to those networks."  Lee Dinstman, a partner at the Agency for the Performing Arts, explained, "The fact that [Warner] has the freedom to take a creative idea to the proper home, instead of just selling to a captive network, can be incredibly attractive." 

What happens if the two firms merge?  Will the loss of independence hurt the Warner production studios?  Put yourself in the position of a programming chief at one of the other major broadcast networks.  When Warner Brothers studios comes pitching a new TV show, what will you think?  You might wonder:  "If it's such a great show, why is it now being broadcast on Fox?"   You may conclude that Warner Brothers is trying to push lower quality shows out to your network.  Note that many firms are vertically integrated in the industry.   Many of the in-house studios at other firms place most of their shows on their own networks. For instance, the article notes that Fox studios has 18 shows on major networks at this time; 14 of them are on the Fox network, while only 4 have been sold to other networks.   Is that because it's the most profitable decision, or is it because other networks are reluctant to buy from the competition?   That, in a nutshell, is one of the perils of vertical integration.  A firm such as Warner Brothers ends up competing with its own customers, creating some challenging conflicts of interest. 

Big Monster Toys: When Vertical Integration Provides Speed

Readers of the blog know that, from time to time, I've discussed the costs and benefits of vertical integration.   In many cases, vertical integration can be problematic.  It can increase fixed costs, reduce flexibility in the supply chain, dull incentives, create dysfunctional political bargaining, etc.  However, vertical integration does make sense in some cases (see Apple owning retail stores).    

Can vertical integration make coordination more effective and actually increase speed?  At times, it can. Witness Zara's fast fashion strategy, enabled by vertical integration.  This week, I ran across another company that achieves speed through vertical integration.  In the American Way magazine on my flight yesterday, I read about Big Monster Toys.  The company invents toys, which are sold by major toy companies such as Hasbro and Mattel.    They created "Polly Pockets" and "Uno Attack!".   They also created Hot Wheels' Criss Cross Crash.  How do they achieve remarkable success in the toy design business?  Here's an excerpt from the article:

The train’s-eye view provides the best vantage point of the work floor and the key to BMT’s success: vertical integration. Every function required to make and promote a prototype is performed in-house, from plastic molding to painting, sound engineering to sewing, computer-aided design to animation. “We control everything,” Rosenwinkel says. “We don’t go outside to hire anyone; we don’t have to get on waiting lists to get work done. We are very nimble. We can immediately say, ‘We like this idea. Let’s pull a team together and work on this.’ ”

Many design forms operate this way.  They have all the tools and functions required to build prototypes in house.  That enables them to prototype rapidly, and to smoothly coordinate the activity of designers and builders.   Moving all those functions in-house means that they can adjust and adapt rapidly.  

Could Disney Sell ABC?

The Wall Street Journal reports today that Walt Disney CEO Bob Iger indicated that the company would not be divesting its local television stations.  He said that, as long as the firm owned the broadcast network, it would also stay in the business of operating some local affiliates.  However, when pressed as to whether Disney might consider divesting both ABC and the local affiliates, Iger seemed more noncommittal.   

In my strategic management courses, I push my students to consider the merits of Disney's vertical integration strategy with regard to the purchase of ABC in the 1990s.   Interestingly, many entertainment firms pursued vertical integration strategies at that time (think AOL-Time Warner and Viacom-CBS), but many of those companies have reversed those strategies in recent years.   I often remind students that herd behavior happens in industries... in the 1990s, vertical integration became the conventional wisdom.  At a second glance, there are many arguments against the purchase of a broadcast network by a content provider such as Disney.   Here are two stock charts.  The first shows the Disney stock performance from the day Michael Eisner became CEO until the day prior to the announcement of the ABC deal.  The second shows the stock performance from the day of the deal until Eisner's resignation.   As you can see, the stock outperformed the S&P 500 index by a wide margin prior to the deal, but underperformed after the acquisition.  Clearly, other factors caused the subpar performance post-deal, but still, the chart suggests that this vertical integration play may not have been as positive as envisioned at first.  

Source: www.bigcharts.com

Backward Integration at Starbucks

Source: Wall Street Journal

The Wall Street Journal reports that Starbucks has acquired a 600 acre coffee farm in Costa Rica.  You might ask: Why is Starbucks backward integrating?  They probably do not think they can operate the supply chain more efficiently through vertical integration.   They certainly aren't going to obtain a significant amount of coffee beans through one 600 acre farm.  What are they doing?

They are learning, experimenting, and innovating.  It's a terrific reason to engage in partial/limited backward integration.   Starbucks CEO Howard Schultz explained, "We are talking about doing innovative things we would not be able to do without this farm."   Craig Russell, a Starbucks senior vice president, explained that the company would try to identify ways to address a fungus problem that is affecting coffee farm yields in Central America: "It's a dynamic situation and we will absolutely use this farm for testing different methodologies and ways to use new types of coffee trees we've developed that have become more disease- and rust-resistant."   Finally and most importantly, Starbucks intends to share what they learn about the fungus with other farmers, so that coffee bean production improves overall for the industry.   

This example demonstrates that a small bit of vertical integration (backward) can be very effective as a means of innovation and experimentation.  Many companies simply view vertical integration from the perspective of its immediate effect on the bottom line.   Ironically, many of those efforts actually decrease profits much to the chagrin of senior executives.   Of course, many of those efforts are not small experiments.  They are bold moves down without a good pilot to test the concept.  In this case, a small bit of experimentation could yield large improvements in profits over time.  

JC Penney vs. Zara: How to Reduce Markdowns

Frequent markdowns can eat into a retailer's margins quite substantially.  No wonder, then, that Ron Johnson - the CEO of JC Penney has tried to wean the department store off of its reliance on discounts and sales.  We all know, however, that he has had limited success to date.  In fact, sales have plummeted as customers have revolted at the dramatic reduction in sales and markdowns. 

Let's compare JC Penney to Zara for a moment.  Zara is a Spanish apparel retailer that has done remarkably well over the past decade or so.   Zara manages to offer fewer markdowns than many rivals, and when it does discount its clothing, they price reductions are smaller than those offered by competitors.  How does Zara do it?  They pursue a "fast fashion" strategy, whereby they make smaller batches of fashion items - a substantial percentage of which they make in their own factories.  They change their product mix often, and they react quickly to changing trends and consumer tastes.  Customers know that many lines of clothing will have limited numbers of items, and that those items may not be on the shelf one month later.  As a result of this nimble strategy, Zara minimizes the downside of "fashion misses" in their product line.  Because they don't produce huge runs of some of these items, they have much less inventory left over if a new product is not a hit with consumers.  Therefore, they have less of a need to mark down those clothes.  

In short, Zara has reduced its dependency on markdowns, but they have not done it simply by declaring that there will be less discounts.  They have built an entire strategy that makes it much less likely that they will need to discount items.  JC Penney hasn't yet built that comprehensive strategy to support its  new pricing policy.  As a result, JC Penney has struggled. 

Google, Motorola, and Android

When Google purchased Motorola's cellphone business, it became vertically integrated.  In other words, it now owns produces the mobile phone hardware and the software, much like Apple.   We all know that Steve Jobs extolled the benefits of vertical integration in the various businesses in which Apple competes.  He believed fervently that one could only produce a "magical" device if you made both the operating system and the hardware.  

Vertical integration has many benefits, but it also comes with certain challenges.  In particular, it can be quite challenging when you start out competing in one portion of the value chain and then enter a downstream business.  Google did so when it began by making Android and then acquired a cellphone maker.  In so doing, Google now has entered into competition with its customers.  After Google's customers for its Android software include Motorola's competitors: Samsung, HTC, and the like.  That competition with customers can be a tricky thing to navigate at times. 

According to this article in Fast Company by Farhad Manjoo, Google has chosen to deal this sticky situation by "erecting a firewall between Android and its new Motorola division. The new rules ensure that Motorola's hardware teams get no more access to Android's engineering teams than any other device maker would."   Surely, the firewall helps allay customer concerns that Google may be favoring its internal Motorola division over other cellphone makers.  On the other hand, such a firewall clearly diminishes the very benefits of vertical integration that presumably drove Google to make the deal in the first place!   What's the explanation here?  Could Google have underestimated the push-back from customers when they made the acquisition?  Or has Google chosen this firewall strategy as a temporary transition mechanism as they work through customer relationship issues?  Surely they won't leave the firewall in place forever, will they?  If so, then why buy Motorola at all?  What value does owning the hardware business bring if you don't make the software and the mobile device work together harmoniously?

Vertical Integration at Lenovo vs. Outsourcing at Rivals

The Wall Street Journal has an article today about Lenovo's vertical integration strategy.  That strategy stands in stark contrast to many of the firm's rivals in the computer business (including Apple), which have outsourced many aspects of the manufacturing process.   Lenovo CEO says, "Selling PCs is like selling fresh fruit.  The speed of innovation is very fast, so you must know how to keep up with the pace, control inventory, to match supply with demand and handle very fast turnover."  Lenovo's SVP of supply chain says, "Three years ago the whole industry was saying everyone should outsource, that's the future.  [We] came to the conclusion that even though all our other competitors are going in the other direction…we can move faster if we're more vertically integrated." 

I'm surprised by the comments, and frankly, by the strategy.   Most people would agree that Apple is one of the most innovative and highly differentiated companies in the computer industry.  If Apple can achieve that type of rapid innovation without being completely vertically integrated, then why can't Lenovo?  Apple pursues vertical integration on selected components, most importantly on its operating system.  However, Apple does not keep all manufacturing in-house.   Lenovo chooses to use outsiders for its operating system (Microsoft Windows for its PCs and Google's Android for its new tablets).    Yet, Lenovo is manufacturing many hardware components in-house.   Time will tell if the strategy will pay off.   One wonders if the path to successful innovation, though, has more to do with company culture, leadership, and new product development processes, rather than with the extent of vertical integration. 

Microsoft Surface: What's the Strategy?

Microsoft's decision to build its own tablet computer (called Surface) has raised some interesting questions about the firm's strategic intent.   Has the firm finally acknowledged that Steve Jobs was correct when he said that you had to be vertically integrated to produce something as terrific as the iPad?  In other words, did the same firm have to make the hardware and the software, because complex integration was needed to deliver a exceptional customer experience?   Jobs, of course, believed that Android devices could not match the iPad experience because they lacked such sophisticated integration (since the hardware makers were simply licensing the Android system). 

A recent New York Times story suggests an alternative hypothesis:  Has Microsoft decided to move temporarily into the tablet hardware business so as to drive the type of innovation that could lead to lucrative tablet operating system and software sales down the road?   Toward the end this New York Times article, MIT Professor Michael Cusumano offers his take on Microsoft's latest move.  Here is the excerpt from the article:

Some who study the technology industry still believe Microsoft will get out of the business of selling its own tablet computer as soon as it can persuade other hardware companies to build compelling devices of their own. “I think once they jump-start it, they plan to make money the way they always have — from licensing software,” said Michael A. Cusumano, a management professor at M.I.T. 

I found this hypothesis quite intriguing.  I can think of at least one other example of a company choosing to vertically integrate on a "temporary" basis.   Coke and Pepsi both chose to forward integrate into bottling and distribution some years ago, and then they divested those units.  Why the back-and-forth?  Some (including HBS Prof. David Yoffie) would argue that Coke and Pepsi forward integrated  so that they could acquire and consolidate their distribution network, driving economies of scale throughout the channel.  They also wanted control of the channel at times as their product strategies shifted.   However, the firms didn't want to have all those assets on their books for the long haul, given the returns in bottling and distribution are much lower than in concentrate production.   Of course, both chose to forward integrate once again more recently, and now we hear rumblings (particularly at Pepsi) of the possibility of another divestiture down the road.  Again, forward integration may have served a distinct strategic purpose, but the firms may find themselves questioning the returns on the distribution businesses. 

Similarly, Microsoft may not want to be in the hardware business long term, as the returns are likely to be lower than in the software business (at least if the tablet market operates in a manner consistent with returns in the personal computer market).   However, "temporary" vertical integration may be their way of shaping the industry in the way that will be positive for them in the long term.   We'll see which hypothesis turns out to be correct.  It should be fascinating, and of course, it will depend on how well customers receive the Surface product. 

Made in the USA: Can it be a Differentiator?

How does a furniture maker compete with low-cost rivals producing goods in China?  It has several options.  It could outsource to China itself, so as to make its furniture more economically.  Alternatively, it could continue to produce in the USA, but try to differentiate its product so as to justify a significant price premium.  The latter strategy can be very successful in some product categories, but it has been difficult in a category such as furniture.   The Wall Street Journal reports, however, that one crib manufacturer is trying to produce a premium product right here in the US.  The Stanley Furniture Company hopes to persuade customers that they can worry less about product safety recalls if they buy from a company producing cribs in the US.   They also offer a wide variety of colors and designs, many more than can typically be provided by a firm producing its cribs off-shore.   However, Stanley charges a significant price premium - $700 vs. roughly $400 for many cribs made in Asia. Stanley is counting on the fact that customers are less sensitive to price when it comes to their infants.  Moreover, grandparents often contribute a significant amount to the purchase of a crib, according to the firm's research. 

Will the strategy work?  It could work, provided that Stanley delivers on its high quality promise.  Beyond that, though, the firm ought to think about the potential advantages that vertical integration may offer.  For instance, producing the cribs in-house here in the USA gives the company the opportunity to do more than offer many different colors and designs.  It also can change its designs much more frequently than an off-shore manufacturer can.  Moreover, it may even be able to offer some level of customization to the consumer.   Mass customization might help support a hefty price premium.    In all these cases, the company relying on outsourcing has a disadvantage, as they will be counting on large production runs of standardized products to take advantage of economies of scale.  Stanley could sacrifice those economies in return for providing the customer some benefits for which they would pay enough of a premium to offset the higher manufacturing costs.   Such a strategy comes with some risk, but given that Stanley cannot compete on cost with Asian manufacturers, it may be the only way to go. 

Will Delta really save money by acquiring an oil refinery?

The Wall Street Journal reports today that Delta Airlines is considering the acquisition of an oil refinery as a means of dealing with volatile oil prices. The article reports that Delta could save between $20 and $25 per barrel on fuel costs due to this backward integration strategy. Seriously? This claim represents one of the common myths about vertical integration. I find it hard to believe that the paper published such a claim. People often assume that you can save money by bringing an activity in-house and eliminating the markup/profit margin that the outside party was taking. This "savings" is completely false. You only get that "savings" by investing a ton of money in new assets you did not own previously! There is no free lunch! Later, in the "Heard on the Street" section of the paper, we see much more thoughtful analysis. There, the writers point out that Delta could achieve a similar result with a long term contract securing a certain fuel supply at a particular price; why vertically integrate, with all that capital investment, when contracts could achieve much the same result?  Whenever firms horizontally or vertically integrate, they should always ask whether they could achieve a similar outcome through a contract or long-term partnership.

In the segment below, which aired on CNBC, we hear a discussion of Delta's latest strategic move: