Horizontal & Vertical
On integrations and stacking + Peloton
Friends,
I hope that everything is well with you and yours on this February Friday morning.
Today, as promised, we are going to go into a few practical strategic choices that many companies have to make at the moment, be it legacy businesses that go through transformation processes (of the digital kind or other) or start-ups looking to navigate their competitive space.
A short run off piste
But before we do, I have been asked to briefly comment on what is currently happening to Peloton (aptly framed by my co-conspirator James Hankins):
The company soared to great heights during the Covid outbreak as gyms closed and consumers were left with few quality options. Overreactions followed as expected, with everyone from charlatan bullshit peddlers to analysts who should know better falling over one another to declare how the business would change everything forever. Scott Galloway, for example, claimed that Peloton’s rally would ‘outlive the Coronavirus’ because it ‘checked many of the boxes in the T algorithm’; an ‘algorithm’ that consisted of eight factors that ‘could take a company to a trillion-dollar valuation’ (and conveniently was/is taught in his strategy course, complete with a direct link to the sign-up page).
Now, reality is starting to catch up.
As losses have mounted ($376 million net in Q3 2021, $439.4 million net in Q4), company shares have tumbled (80% in the last twelve months, more than 70% over the past three); Peloton’s market value has fallen from above $50 billion to under $10 billion, and some investors are actively betting against the stock. Instead of a growth narrative, the story now is very much one of cost-cutting. McKinsey has been brought in to help, production has been halted and employees have been informed of moves to ‘right-size’ the organization (a terrible soft language evolution of down-sizing that shifts blame to the victim) to the tune of 20% of the workforce – many of whom reportedly discovered that their size had been corrected by no longer being able to log on to the company Slack.
This, I am sure, must have been a surprise to the kind of talking head who thought the company would do what no other company had done before because it supposedly took advantage of so-called fandoms, niches, mini-brands or whatever else. For those more interested in the strategic implications of market realities than nonsense and hyperbole, however, the risk of recent events was evident.
For one, Peloton’s boom during Covid was, much like Zoom’s, in no small part due to the realities of lockdowns and social distancing. That growth would continue in the same trajectory after the pressure of the pandemic lessened was always naïve at best.
But there was also the fact that success breeds imitation. A number of direct competitors entered the market, many of which were easier on the wallet than any of Peloton’s models and subscription alternatives. Indirect competitors gained traction too, not least Apple with its Fitness+ digital workout service. Then, gyms started to reopen. Given the frankly rather amateurish company setup, it should not have been surprising that the gathered clouds grew dark fast.
That is not to say that the company is without merit; it has a decent business model both from a revenue and data collection perspective, and millions of users with sunk costs (and therefore biases for continued usage). While its value to the public is up for debate, it could prove valuable to a company looking to diversify or strengthen a strategic position. Amazon, to mention but one potential acquirer, has broad ambitions in healthcare and wellness, a strong distribution network at its disposal, and the funds to make the acquisition (although determining the price might turn out to be a pain in the proverbial).
The key for high-growth businesses such as Peloton often lies in getting the boring fundamentals correct and building the strategic resilience needed for when the hockey stick inevitably becomes an s. If they are to make it (back or just full stop), it appears obvious that the company therefore has to – either on its own or with help from a new owner – improve its strategic and financial management, sort out its many corporate governance issues, define boundaries for future undertakings, stop falling victim to heavy buyer fallacies and, as entirely unsexy as it may sound, do things properly. Hardly revolutionary insight, admittedly, but nonetheless true.
The actual topic of the day
A week ago, we took a look at the resource-based view of the organization and established that rather than a substitute for the external-internal approach to strategy, it should be seen as a complement to it.
Today, we are going to continue on a similar theme, albeit from the perspective of a significantly more specific practical problem.
The debate between horizontal stacking, horizontal integration and vertical integration that rages in industries demarcated by rapid technological change at the moment is, by and large, an argument over complements and potential substitutes. Although the context often is claimed to be and may appear novel, the underlying issues should be familiar to anyone with knowledge of strategic movements throughout history.
But let us first define terminology so that we all start on the same page.
The notions of vertical and horizontal integrations are reasonably well established in both strategic management theory and practice. Vertical integration refers to increased ownership of the total value chain (a concept in turn introduced by Michael Porter), such as taking control over production or distribution. Horizontal integration, meanwhile, deals with the broadening of operations at one level of it, typically through the means of mergers or acquisitions.
From this, we also get the sub-concepts of backward and forward integration.
Horizontal stacking is, by comparison, an ‘evolving concept’ and consequently subject to a myriad of interpretations of varying degrees of intelligence. For the purposes of the present conversation, I am going to define it as strategic cooperation with highly specialized providers of complementary solutions on the same horizontal level.
The reasoning behind my (to some perhaps overly wordy) version is that there is exists a distinct difference between the meanings of stack and stacking. While the former refers to a collection, the latter refers to the act of collecting. Put differently, a horizontal stack can be used as a collective noun to describe direct-, indirect- or non-competitors all acting on one level, whereas horizontal stacking is bundling a number of them together to serve a specific purpose (usually optimization).
Lastly, I should explain what I mean by substitute and complement. In strict economic terms, two goods are considered substitutes if the consumption of one increases when the price of the other does (all else being equal). If, on the other hand, the consumption of one increases when the price of the other decreases, they are complements (again with caveat of all else being equal). For the time being though, it is probably sufficient to think of substitutes as being able to solve the same problem while complements are best together.
The proposition
Fundamentally, then, we have three theoretical options on the table.
Corporations can aim to own more of the value chain (forward, backward or full vertical integration),
own multiple companies that act more or less independently on the same level of the value chain (horizontal integration), or
utilize any number of service providers that have managed to solve specific different tasks on the same level of the value chain (horizontal stacking).
As one might expect, each approach has its respective benefits and drawbacks.
Those of integration processes are relatively well documented. Vertical integration can lead to (among other things) cost savings, but requires steep investment to get there. Horizontal integration can lead to higher growth, lower competition and access to new markets, but also regulatory scrutiny due to potential market power skew, value destruction and unrealized synergy effects as a result of clashing company cultures.
When it comes to horizontal stacking, its main sales pitch is that it allows organizations to focus on their strengths. Any weakness can be outsourced to companies for which it conversely is a main area of expertise. As such, subscribers will recognize, it echoes the refrain from core competencies; do what you do best, let others handle the rest.
It is a proposition that ostensibly makes sense. Few companies can afford to make up for every skill and capability deficiency through integration. Fewer companies still can afford the failure rate of markets. Identifying the solutions that prove to work, or at least seem promising and important, and building partnerships with the companies that best provide them, can save a lot of time and money (although one should note that it is a taller order in practice than many let on).
Given that a crucial aspect of strategy is deciding what not to do – where to draw the boundaries in the ABCDE framework – it is only natural that horizontal stacking is becoming an increasingly common conversation in C-suites around the world. Complementary solutions can not only augment the overall value proposition, but also allow for higher operational efficiency.
The problem
But, as anyone who has studied the trends and fads of strategic management throughout the years will know, there is no such thing as a risk-free handoff. Complements can become substitutes.
To illustrate, a Buy Now-Pay Later (BNPL) company can be seen as a horizontally stacked complement to legacy credit card providers; the consumer can (indeed often is recommended to) make any online purchase using their card of choice. All parties seemingly gain from the transaction. The BNPL collects a fee, the legacy company collects a fee, the merchant achieves a sale, and the consumer achieves their goal.
Yet it is not actually in the BNPL company’s interest to maintain this chain of commerce. Over time, the fees that legacy card providers demand from BNPLs for using their networks add up to the point where profitability is practically impossible to achieve. The BNPL would therefore rather that consumers pay direct, either by in-app balance or from their bank account. At this point a different network (typically ACH, i.e., Automated Clearing House) is used. It carries a much lower fee than the credit card networks – and frequently none at all. Paying direct, in other words, means that the credit card company is effectively disintermediated as the complement becomes a substitute. Incentives and threats go hand in hand.
Similarly, it is becoming increasingly popular to horizontally stack solution providers in e-commerce and DTC. For example, getting one’s products on Amazon can massively improve distribution and sales, and utilizing specialist delivery firms can help with final mile optimization. But Amazon takes notice of what products become best sellers. Eventually, they may decide to launch their own alternatives and cut off marketplace access for anyone deemed a competitor. Delivery companies can keep tabs on what products customers prefer and begin offering their own versions too, something currently being done by Gopuff and Buyk. In both cases, short-term horizontal stacking leads to long-term vertically integrated competition.
Predictably, horizontal stacking also carries many of the traditional outsourcing problems, such as potentially losing future sources of profit, IPs and insight into important market changes, causing misinterpretation. Companies with deeply ingrained organizational routines habitually have a difficult time responding to new ways in which parts of a system (e.g., a product or a production process) interact with one another, and stacking can make it worse.
Then, there is the reduction problem. As we have established time and again, companies are complex adaptive systems. This means that they are inherently impossible to reduce; they function like ecosystems, not machines. Taking out parts or failing to develop capabilities therefore often leads to unforeseen consequences.
A well-known example of this can be found in US manufacturing a few decades back. In a desperate attempt to emulate Japanese industrial success, companies adopted lean management principles without realizing that the value of an individual practice was tightly coupled with the presence of other practices. As a result, the changes took a long time to implement and typically ended up hurting the companies.
The long and the short of it
I could go on, but I suspect that the point is made.
Horizontal stacking is currently argued for in terms that make it appear without drawbacks, a no-brainer. However, strategists with brains should observe that it is a much more nuanced strategic conversation than popularly claimed. Although stacking can lead to higher operational efficiency and an overall value addition, there are long-term strategic risks that must be weighed against the short-term benefits of the endeavor.
Certainly, some of the risks can be mitigated; incumbents with significant market power can, if nothing else, enforce non-compete clauses (provided they are not deemed to be market manipulation). But others will always remain. In order to handle them, one should learn from similar conundrums throughout history; not for any hope of a blueprint, but a starting point.
Next week, we are going to delve into Kenichi Ohmae’s 3C framework. Until then, I wish you the loveliest of weekends.
Onwards and upwards,
JP