The Case for Verticalization
What’s the right equilibrium for specialization?
Exploring the unobvious ties between interconnected but different ecosytems, and defending the relevance of “verticalization” — which recovers various realities, as well as arguing that it already is a deep-rooted force. Verticalization as a key concept for the years to come.
Horizontal integration and globalization
Horizontal integration (or “horizontalization” for the purpose of this article) has been a trend at work in many industries for the last decades. It consists in acquiring business or developing offers on specific latter of the value chain in similar or different sectors. It has been encouraged by specialization, development of outsourcing possibilities, liberalization of the exchanges and in one-word globalization. It usually stands in contrast to “verticalization”, or vertical integration, a strategy which, in short, involves the expansion of business operations along different steps on the same production path, such as when a distributor starts manufacturing part or all of its inventory. These two concepts can be interpreted both on micro and macro levels.
Horizontalization is a phenomenon that can be observed across industries and companies’ sizes. It has proved useful to help companies focus on their “strong force” (Pareto) and /or on the most value-adding aspects of their businesses. In some instances, it helped corporations to re-invent themselves and remain relevant. IBM, which progressively divested from integrated legacy product lines like memory chips, technology components, printers, displays and personal computers to focus on cloud computing and Artificial Intelligence is a good example.
A rapid look at the macro tendencies at work confirms that globalization has both been a catalyzer and a result of this increased horizontal integration.
a) Catalyzer in the sense that it accelerated outsourcing of “non-core” and “less value-adding” aspects of the activities of developed countries’ corporations to other countries, particularly in Asia. One could argue that this turn of events was, at least for a while, mutually beneficial in terms of development strategy, seeing how then-emerging countries such as South Korea, thrived by successfully re-capturing lower value industries in a successive sequence: first textile, then cheap electronics, then middle-range electronics, etc. In that sense horizontal integration has specialization as corollary and resulted in increased overall welfare.
b) Result because increased liberalization of international trade of product and services encouraged companies to meet challenging growth objectives by replicating and exporting their brand, model (franchising), goods, or solutions in ever more markets. This “go global” recipe guaranteed healthy sales developments. Collaterally it provided easy outputs for companies, which, in closer markets, would have been constrained to battle and innovate fiercely to remain relevant. This global shift has logically been echoed by intense consolidation movements across many sectors — also bearing negative effects on innovation and competition.
When it comes to the larger software space, which is a good case study, since horizontal development is made easier by the dematerialized character of the “raw material” and ever-increasing uniformization of the standards, the horizontal integration has been the go-to model for the vast majority of software and infrastructure providers. Client acquisition can be done faster, products do not require high degree of differentiation, which makes the replication easier and the specialization successful.
Following this rapid overlook on traditional drivers behind popularity of horizontal models, and their takeaways in terms of business and global economy, we will consider which forces are prompt to accelerate verticalization. This is an idea which, while surprising and to some extent “politically incorrect” in an ever increasingly connected world, correlates well with the actual evolution of our society.
At the expense of innovation ?
First a few words to quickly expand on the above introduced idea that innovation maybe a collateral victim of horizontal integration. It is apparent that beyond the concentration factor mentioned, which understandably plays against competition and hence innovation, globalization has fostered (or is it the other way around: “been fostered for”?) a form of laziness in global business. Indeed, to expand the bottom line, instead of commiting to ambitious R&D projects, improving operational performance, finding creative ways to monitor supply chain, why not just exporting and replicating the same product quasi-infinitely in foreign territories? And pushing regulators and academic models in that direction? Increased shareholder pressure for short-term wins plausibly encouraged this type of behaviors which in some respect conflicts with the quest for superior products and technology. Not too delve too much on the following correlation — in view of the number of parameters that come into play- but it’s also consistent with the observation that most national currencies have been losing ground (to, let’s say CHF) very consistently in the last 30 years. Easier to put goods or services on sale in a world where number of transactions increase exponentially than to maintain a demonstrated superiority in quality to deter competition.
“May you live in interesting times! “
One currently observes the following macro-trends:
a) The processes described in the first paragraph contributed to “make the world smaller” to many multinational corporations.
b) Due to technology transfer and increased overall level of education, the technological gap between emerging and developed countries becomes ever more narrow. In parallel some technologies are easily reproductible, as with many applications and B2C software products.
c) Some countries (e.g. China, Russia) put more restrictions when it comes to opening up their markets. And it’s easily understandable. Since the above described processes also contributed to “flatten” the technology and that the constitutional technical know-how behind multibillion corporations is not that hard to reproduce and/or protected by some key patent, why would they bother and simply offer their vast markets to western firms? Better create their giants of their own: WeChat, Didi Chuxing, Weibo, etc.
These three factors concur to fragilizing the horizontal integration model.*
And consequently, pushing for vertical development. What does it entail?
Living in a “smaller world” where technical competencies are increasingly available means intensified vertical focus will be regarded as attractive to achieve differentiation, strategic advantage, and product superiority. It will imply shifts that seem counterintuitive now: be closer to local communities, have inclusive and detailed view when considering company extensions, develop tighter production integration, look at distribution differently, source exclusively, focus on R&D, limit obsolescence of the products.
Above all it suggests a different outlook on the critical concept of scaling. Models involving mere replication or update of one similar offering might find their limits. Business efficiency, logistics, supplier selection and/or acquisition, process optimization might grow in importance rapidly as a source of revenues, and differentiation factor.
The following lines will attempt to provide further illustrations of that fact.
*(Side note addressing above paragraph touching on horizontalization in the perspective of development economics: the virtues of globalization (condition and consequence of horizontal integration) have not been evenly dispersed between countries. Models proved fit for some of them, such as the South-East Asia Tigers, which successfully implemented them, while no so much for others like Algeria or many South-American countries. Furthermore, within each country, even the most developed ones, this global shift didn’t favor all population unilaterally, far from it. Prevailing international trade models, like Heckscher-Ohlin Model, cornerstone for herein-described development strategy, argue that countries should trade intensively the production factor they have in abundance (horizontal integration), like for example cheap labor, while exchanges of capital, goods, and labor, should be frictionless, all to increase the output. While convincingly getting the point across that global output can be increased this way, these models however fail — and this is a major hick-up — to explain how the newly bigger output will then be distributed amongst the ones that contributed to generate it within the respective markets, and in particular between shareholders and employees. It could be validly observed that short-term winners of globalization and horizontalization are Asian (former) emerging countries and upper to wealthy groups in developed countries, both on the revenue and consumption fronts)
Another company-level strategic consideration is at play. As global companies achieve their target of having a strong anchor in their elective value chain ladder and simultaneously global reach, they aim for vertical integration in an effort to increase their margins. Typical example would be Netflix here, or Amazon. This shows that while the win of a market may be attained through horizontal application of one specific offer across a wide variety of geographical or industrial positions, often at the expense of comfortable profits initially, the quest for margins and revenue diversification is associated to vertical integration.
In this instance vertical integration also raises the question of global vs. local again (the “glocalization perspective”). Expectably this is less of a hurdle for companies selling dematerialized products, as Netflix. The balance between these two forces might be more challenging for companies like Airbnb; as they move vertically along the chain, and start renting their own flats, or associate with local promoters to start their own developments, they need to be deeply committed to local ecosystems and body of rules. This fine equilibrium, conditions of which being defined on a case by case basis, has been a key standard for successful international management and will become increasingly meaningful. It also holds practical implications in fiscal and foreign investments terms.
Lowest common dominator vs. surgical action
As commented a few lines above, digitalization played centric role in recent macro-evolutions; consistently weight of digital services in the overall economy expanded sharply.
Digitalization is a broad word that takes on many forms. Arguably for a while it meant, for many brick and mortar businesses, having a basic website with a contact form, and then, allowing to register for a service, or to check one’s balance account online rather than offline. It went on to influence the distribution, the communication and the very business models — even for non digital-native companies. As previously hinted, digitalization has been instrumental in the expansion of outsourcing possibilities.
Consequently, many IT firms relied on a horizontal business model. They would provide basic tooling required for primary online presence: hosting, security, possibility to register a domain name easily. Gradually such IT firms went on to provide mobile applications, design, debugging, redundancy, etc. The most successful ones did extremely well by offering these “one-size fits all” tools across a wide range of industries.
With the advent of big data and AI however, many businesses are now looking for more: detailed business analytics, performance measurements, increased efficiency, automation, and ultimately optimization. Along this path the “one-size fits all” model has shown its limitations.
So as executives turn to machine-learning-based solutions, it is becoming a major business case for software companies. But to perform well, good data engineering and mastery of machine-learning operations alone is not sufficient: solution suppliers need proprietary data sets, sharp understanding of the business functions behind AI applications, clear definition of the problems to solve. This mechanically implies that these software suppliers will put extended emphasis on sharp vertical focus on distinct industries and/or company. It demands corresponding in-depth domain knowledge to a point where software companies hire domain specialists and strongly identify with their target clients; examples range from medical industries, to food-processing, to construction, etc.
And, mirroring that trend, infrastructure layer, previously considered one of the pillar of IT solutions for business, are mechanically becoming “utilitized”, as incremental value from such solutions providers tends to migrate to sharp predictions and activatable recommendations in a clear-cut vertical AI layer.
All in all,
while horizontal integration proved to be an important vector of growth and “quick wins” for many companies and some countries and/or populations within those countries, it is currently showing limitations. One of the most compelling objection that can be made is that it somehow contributes to “fix” or “restrict” innovation. Therefore, while this post doesn’t have the pretention to provide an exhaustive redefinition of international management and sales best practices, it is worthwhile to point out seemingly dispersed factors that strongly favor the mutation of mainstream business models.
On various levels, critical incentives such as differentiation and margins may come from adopting a stronger vertical focus and commitment to internal performance. In a smaller world, where more countries are competing in high valued-added segments, where companies need a firm grip in their industry of election, verticalization may not be a choice. Event in IT, where “software is eating the world”, the sharpest players may need to adapt their approach to the market, to fit this criterion.
Practically and theoretically speaking there is a case to be made for verticalization.
More than a case, it’s an underlying trend which is at work already, but which hasn’t been labeled explicitly, and whose exact shape is waiting to be coined. In that respect it induces fundamental questions such as:
What will be the new deal between local and global activities? For product and marketing mix? On a wider level, will geographical markets be more differentiated? And, critically: What will be the new paradigm when it comes to scaling — a key concept for any venture?
If — to summarize — “now that tech is spread and economy is globalized, reservoir of growth remains in the verticalization”, this discussion opens up on many parallel debates. One of them is considered a “dirty word” by many scholars, politicians and businessmen: protectionism. Economic cycles tend to contract and relax like a breathing movement often navigating between extreme points. GATT 1994 agreements and many parallel regional dispositions opened the door to an overtly opened world. Now that both micro and macro forces are reshaping prevailing archetypes, is there room for intelligent protectionism there? For example, based on measures imposing multinational corporations to fully pay their taxes locally (Paradise papers seems to suggest that this one is highly needed), to invest heavily in markets they wish to conquer (vertical integration), restricting public tenders participations from companies benefiting from foreign subsidies, etc.