On Vertical Integration of Tech Giants

 Apple is generally believed to be the first tech giant to really understand the value of vertical integration, by maintaining control tight control over hardware, software and online stores and more. iPod’s system, especially is heralded as the poster child of such idea, which includes the online iTunes music store, iTunes software on PCs and iPod hardware, creating a powerful ecosystem that helped Apply handily beat competitors such as Creative Labs and Microsoft’s Zune. It seems like many of Apple’s competitors are embracing its vertical integration approach. Microsoft is rumored to be making its own phone hardware, despite its partnership with Nokia, Samsung has always been a manufacturer of chips as well as hardware and there is a recent news that Amazon is in advanced negotiation to buy Texas Instruments’ smartphone and tablet oriented OMAP chips, which happens to power Kindle’s competitor Nook.

I believe that there are some clear advantages to vertical integration. First is the company’s ability to control costs. By being in firm control of the costs and design of key component such as chip technology, it gives cost advantages to the company employing vertical integration. Secondly, vertical integration gives the company freedom from being tied to key suppliers of such key component, resulting in greater negotiating power. Lastly, it gives the company ability to create an ecosystem where it can directly control the user experience within the network. iPhone’s seamless integration with Mac family, iPad, iTunes and iTunes stores is a great example of a closed ecosystem with wonderful user experience that creates brand loyalty and a moat around its business.

Obviously, there are costs associated with pursuing vertical integration, which is why many tech giants stayed out of it. One of the downside is the lower motivation for excellence in quality as sales is pretty much guaranteed. Apple steered away from this by outsourcing aspects of hardware production to companies such as HonHai and Samsung and creating a strict bar for quality. Another cost is the increased complexity in coordinating different activities to create a seamless experience for the end user. The opportunity cost should also be considered. If you are excellent in certain channel (online sales or Kindle software for Amazon’s example), should you go into direct publishing or chip manufacturing? Either you can license your technology for a much wider audience or you lose efficiency or corporate focus by expanding vertically where you didn’t have core competency to begin with.  

Current trend seems to suggest that several tech giants believe that Apple’s vertical integration model was correct and that they can execute as well as Apple. Another recent example is Microsoft’s effort to utilize its existing user base (Windows Phone, Windows 8 Tablets, PCs) to create a music network and thus an ecosystem away from Apple’s iTune by introducing xBox Music. Kindle’s business model of not making profit off hardware (as widely reported and confirmed by Jeff Bezos) and instead aiming to profit in content and online marketplace, especially in books, is another effort to create an ecosystem by being a provider of both hardware and software. Buying Texas Instrument’s smartphone and tablet chip business could certainly make Kindle hardware business into a profit generating proposition in its own right, which might explain why Amazon is interested in such a deal, especially given Amazon’s scale at this point. I believe that with the right scale, strategic goals and ability to coordinate the operation internally, vertical integration and creating a defensible ecosystem could be a winning strategy. Without such focus and determination, however, vertical integration could well be not much more than an amalgamation of businesses that you didn’t really need to own to “kill it” in the industry.