Interesting article in today's WSJ:
Larry Ellison is known for forward thinking. With his new business model, though, the billionaire chief executive of software maker Oracle Corp. is taking a page from the past.
Mr. Ellison plans to buy Sun Microsystems Inc. and transform Oracle into a maker of software, computers, and computer components -- a company more like the U.S. conglomerates of the 1960s than the fragmented technology industry of recent years. ...
Mr. Ellison is among the executives reviving "vertical integration," a 100-year-old strategy in which a company controls materials, manufacturing and distribution. Others moving recently in this direction include ArcelorMittal, PepsiCo Inc., General Motors Co. and Boeing Co.
The reasons vary. Arcelor, the world's largest steelmaker, wants more control over its raw materials. Pepsi wants more authority over distribution. GM and Boeing are moving by necessity, to assure quantity and quality of vital parts from troubled suppliers. Some are repurchasing businesses they only recently shed.
"The pendulum has shifted from disintegration to integration," says Harold Sirkin, global head of the Boston Consulting Group's operations practice. He attributes the change to volatile commodity prices, financial pressures at suppliers and quests for new revenue -- challenges exacerbated by the recession. ...
The moves toward vertical integration are a departure from the past half-century, when companies increasingly specialized, shifting functions like manufacturing and procuring raw materials to others. Steelmakers in the 1980s sold their mining operations; in the 1990s, auto giants spun off their parts suppliers. Tech companies stopped making every piece of a computer system and specialized in chips, data storage or software. ...
While many companies, such as Coca-Cola Co. and Toyota Motor Corp., are content to stick to their current business models, others find they have little choice but to vertically integrate. In the past two years, Boeing bought a factory and a 50% stake in a joint venture that make parts for its troubled 787 Dreamliner jet. The moves partially reversed Boeing's aggressive outsourcing strategy to assemble the Dreamliner from parts made by hundreds of suppliers. Supply and assembly problems have knocked the Dreamliner more than two years behind schedule. Boeing CEO Jim McNerney says the company is still committed to outsourcing.
Likewise, GM in October took a minority stake in Delphi Automotive LLP, its biggest parts supplier, and purchased four factories and Delphi's steering business as the supplier emerged from bankruptcy. GM, which spun off Delphi in 1999, wanted to assure uninterrupted supply, a spokeswoman for the company says. ...
Perhaps the most dramatic reversal is taking place in the tech industry, where specialization and outsourcing had dominated for decades.
At the outset, let's clear up one misconception in the article. What is happening here is not a revival of 1960s-style conglomerates. They were a very different beast.
Around the middle of the 20th Century, the idea grew up that good managers could manage anything. This view was operationalized via conglomerate mergers, in which companies intentionally sought to diversify their product lines and business activities horizontally across a wide array of unrelated businesses. The theory was that a cyclical manufacturer could buy a noncyclical business, making the combined company stronger because some division would always be doing well. Diversification necessarily reduces the maximum gains a conglomerate can produce. When one segment is doing well, it is being pulled down by a segment that is doing less well. To be sure, diversification reduced the conglomerate's exposure to unsystematic risk. But so what? Investors can diversify their portfolios more cheaply than can a company, not least because the investor need not pay a control premium. Management of a conglomerate may be better off, because their employer is subject to less risk, but the empirical evidence is compelling that intra firm diversification reduces shareholder wealth. The self correcting nature of free markets is demonstrated by what happened next: during the 1980s there was a wave of so called "bust up" takeovers in which conglomerates were acquired and broken up into their constituent pieces, which were then sold off. The process resulted in a sort of reverse synergy: the whole was worth less than the sum of its parts.
The 1960s-style conglomerate was thus characterized by horizontal integration; i.e., mergers across industries. What's happening here is the revival of vertical integration; i.e., mergers and acquisitions within a single industry's supply chain.
Unlike conglomerates, vertically integrated firms have a strong efficiency story. A common efficiency based justification for vertical integration, for example, is the elimination of appropriate quasi-rents. Quasi-rents arise where investments in transaction specific assets create a surplus subject to expropriation by the contracting party with control over the assets. See Benjamin R. Klein et al., Vertical Integration, Appropriable Rents, and the Competitive Contracting Process, 21 J. L. & Econ. 297, 298 (1978). A transaction specific asset is one whose value is appreciably lower in any other use than the transaction in question. Once a transaction specific investment has been made, it generates quasi-rents--i.e., returns in excess of that necessary to maintain the asset in its current use. If such quasi-rents are appropriable by the party with control of the transaction specific asset, a hold up problem ensues.
A canonical example is the fact that historically newspapers owned their own printing presses while book publishers did not. The time pressures of newspaper publishing makes them quite sensitive to opportunism by printers. Suppose the newspaper needed to put out an extra edition, for example. An independent printer might refuse to cooperate, without an extra payment. The printer thus is holding up the newspaper in hopes of getting a bigger share of the available quasi-rents.
Granted, there are contractual solutions to the hold up problem. At the same time, however, history seemed to teach that the intra-firm command and control system allows for discipline of the sort that is not possible outside the firm. Ownership of the asset equates to a higher degree of control. So newspapers vertically integrated—they brought ownership of the press within the same firm as the editorial part of the operation.
Vertical integration thus brings both parties within a single firm and, accordingly, is a common solution to the hold up problem. The Boeing and GM examples cited in the article likely are consistent with this explanation for vertical acquisitions.
The agency cost/opportunism story supporting vertical integration raises questions about why firms turned so heavily in recent decades to outsourcing. Outsourcing inherently creates the risk of opportunism, because it separates control over transaction specific assets and thus creates quasi-rents.
In an important article, George Geis argued that:
The conventional explanation for the rise in business outsourcing is that falling interaction costs have changed this balance by opening new markets where firms can source economic inputs for less. This Article offers a second account, however, for the outsourcing phenomenon - one that is rooted in agency theory. Like many other economic relationships, outsourcing projects generate agency risk because a vendor makes decisions that affect the wealth of the outsourcing firm.
This Article argues that business outsourcing has thrived in recent years not only because globalization has unlocked inexpensive production markets, but also because it is becoming easier for firms to monitor and prevent the agency costs of outsourcing. Drawing upon a detailed analysis of outsourcing contracts, it explores several strategies to minimize agency costs - shedding new light on the structure and terms of a typical outsourcing project. It then contends that the same forces that are opening new markets are also making it economical for firms to mitigate outsourcing agency risk. Taken together, this work adds another important, but previously neglected, context for understanding the essential tradeoffs that arise when economic ownership is divorced from control.
Specifically, Geis argued that:
First, cheaper communication costs and standardized business processes simplify the drafting of detailed work descriptions and performance obligations. Obviously, it will cost less to write a comprehensive (though still incomplete) agreement when expensive international phone calls and business trips are replaced with distributed voice and video networks. Second, the standardization of business processes allows parties to pull performance criteria “off the rack” instead of haggling over the right way to assess execution of the business activity. For example, the metrics to appraise performance in an internet hosting project are now routinely defined to include packet transmission rates, bit-loss frequency, response rates for service calls, and so on. This makes it easier to draft a service level agreement to govern this type of outsourcing project. Furthermore, in addition to economizing drafting costs, standardized metrics simplify efforts to monitor compliance with these SLAs once they are in place. ... Third, cheaper communication, better technology, and standardized business processes make it easier to design and coordinate multiple agent structures or to leave part of an outsourced activity under the principal’s control. ... Finally, falling interaction costs help principals use incentive compatible compensation, control rights, and exit provisions more effectively.
Geis' argument made great sense. If the revival of vertical integration proves a lasting and significant phenomenon, however, we'll have to revisit the agency cost analysis. It may be that contractual solutions to the risk of opportunism inherent in outsourcing are not as effective as Geis and those of us who found his article persuasive (as I did) thought.
Another possibility is that the technological story Geis tells can also be told about vertically integrated firms. Consider that publicly held US firms have had to grapple for years with the enhanced internal control requirements imposed by Sarbanes-Oxley. Most firms have used technological monitoring systems as a key part of their internal control systems. Perhaps technology has reduced the cost of monitoring one's own employees at least as much as it has that of monitoring contractual counterparties. Once firms realized this, maybe the agency cost story for vertical integration started making sense again.
Finally, maybe outsourcing was just a fad. See my post Management fads: A behavioral explanation for an argument that:
Just as some consumers have to have the latest product fads, some managers seem to have to have the latest industrial relations fad. As a result, some firms repeatedly make radical shifts in the way their firms make decisions.
The post then offers a behavioral economics explanation for why managers adopt fads.
Anyway, for those of us who work in mergers and acquisitions, this is clearly a trend worth keeping an eye on. Something very interesting may be happening here.
Updates:
- Larry Ribstein ponders the potential impact a revival of vertical integration might have on his work on uncorporations (see his excellent new book The Rise of the Uncorporation
)
- Gordon Smith argues against "privileg[ing] one form of organization over the other in all circumstances," making a very fair point.