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The key to the expansion of Peloton, Apple, Netflix and Tesla: it's vertical integration

15, 2020

8 min read

The opinions expressed by the entrepreneur's contributors are their own.

Peloton announced blowout wins last week and has joined an elite club that includes Apple, Netflix and Tesla. These companies not only inspire their customers and create enormous shareholder value, but also operate a highly vertically integrated company. The success of these companies consists in rewriting some outdated rules for effective business strategy.

If you want to succeed in today's marketplace, you should understand exactly what is behind the growth of these companies … and how different it is from the way companies think.

A quarter of a century ago, C. K. Prahalad and Gary Hamel argued in their widely acclaimed book Competing For The Future that market leaders owe their success to an identifiable set of core competencies that enable them to outperform the competition. These skills can be in engineering, product design, manufacturing, supply chain management, or marketing and allow their masters to achieve market leadership in a variety of ways.

For example, Walmart used its expertise in global sourcing and supply chain management to gain a huge competitive advantage with a wide range of products at everyday low prices. Toyota, meanwhile, achieved market leadership through outstanding product development and efficient, high-quality manufacturing.

According to theory, to grow big, market leaders should invest heavily in what they do best – and outsource non-core business functions to third parties. Accordingly, Walmart did not want to develop or manufacture its own products, and Toyota left the retailing to independent car dealers.

A decade later, this thinking was picked up by Bain consultants Chris Zook and James Allen, who turned it into conventional wisdom. When Apple first announced plans to open its own stores and Amazon began developing its own consumer electronics, the experts in the business world piled up. In 2001, Bloomberg published a spectacularly misguided comment entitled "Sorry, Steve (Jobs): Here's Why Apple Stores Don't Work". And Amazon has often been denounced after introducing its first-generation Kindle into consumer electronics design for an unfortunate endeavor deemed Hubristian that it was not a part of.

What did these critics miss? They were tied to this "skill-based strategy" – the idea that companies should only focus on what they do best. And they didn't realize that the idea was flawed and growing old.

First of all, they failed to realize that a skill-based strategy often encourages mature companies to hold onto outdated skills and assets that limit growth opportunities. If you stick to your knitting management mindset, you instinctively resist disruptive changes that can cannibalize current sales, and they tend to make strategic decisions inappropriately. Rather than focusing primarily on how short-term assets can be used to increase short-term sales, managers should also ask how and where consumers want to be served and what features are required to best reach them. While Walmart and IKEA have long been leaders in big box retail, both were delayed – and are now playing catch-up! – with e-commerce functions.

Meanwhile, a new generation of companies were much more open to vertical integration in their development – they built and dominated every part of the market themselves. Domestic e-commerce startups like Warby Parker, for example, saw the potential to expand their market reach through physical retail expand. Then they built the required omnichannel retail skills internally.

Startups should be particularly open to building vertically integrated capabilities as soon as possible, as soon as funding capacity, management talent and breadth allow for three reasons.

First, startups often do not have in-depth knowledge of core competencies at the outset. There are no assets or managerial egos to protect, and no sales to cannibalize. Finding the right mechanisms to achieve target market growth are the main drivers of the early stage risk strategy.

Second, for highly innovative companies, the required product design, manufacturing, and sales skills may not be available from third party vendors. This forces participants to build their own skills to support category-defining new approaches. This was the case with both Tesla and Allbirds, who of necessity delved into product design, global supply chain management, manufacturing, and new retail formats to bring their groundbreaking products to market.

Finally, and perhaps most importantly, vertical integration can give organizations more control over delivering superior products and better experiences at every customer touchpoint. For example, it is now widely recognized that Apple's tight control over hardware and software design, as well as having its own stores, have contributed to superior product performance, customer satisfaction and price realization that more than offset the increased costs and complexity of managing a vertically integrated one Company.

Peloton provides another illustrative example.

In 2011, John Foley whipped up an idea for a “connected fitness” company that would ultimately require expertise in hardware design, software development, professional video production, gym operations, and physical retail, none of which would match the background of the Founder corresponded. The original plan was to bring a product with minimal viability by adapting Peloton's own software and electronics to existing bike and tablet computers to allow the products to monitor rider performance in real time and online spin classes can stream. On this and several other key milestones along the way, Foley and his co-founders decided that the company should be better off developing its own products and in-house capabilities than relying on third-party vendors.

Among the skills it created itself:

After Peloton determined that existing bikes and tablets were not suitable for the company's intended use, he designed his own bike from the ground up using entirely proprietary hardware and software.
Peloton recruited and trained its own instructors instead of working with existing fitness boutiques
Peloton set up its own state-of-the-art production studios and fitness boutiques rather than using existing facilities
Peloton built its own network of retail stores to complement its e-commerce channel rather than selling through existing stores
Peloton was backwards integrated into the company's own hardware manufacturing, having initially relied on contract manufacturers
Peloton developed its own delivery / installation service for “white gloves” instead of relying solely on third party logistics providers

This sequence of strategic decisions undoubtedly increased Peloton's capital requirements, which Foley said weighed heavily on the company during its early development. However, when it was found that Peloton was delivering a superior product and customer experience to a rapidly growing base of enthusiastic and loyal subscribers, the company raised nearly $ 1 billion in private capital.

In its public offering prospectus, filed last summer, Peloton described the scope of its vertically integrated activities as follows: We are a technology-media software-product experience-fitness design-retail clothing logistics company.

Peloton's IPO took place in September 2019. By mid-2020, it served more than one million subscribers in four countries and had annual sales of over $ 1.8 billion with strong positive operating cash flow. As evidence of the success of its vertical integration strategy, Peloton currently has higher hardware gross profit margins (45%), higher customer satisfaction scores (93 NPS) and higher customer retention rates (92%) than Apple or Tesla.

Peloton's success is not intended to be a blanket confirmation of a high level of vertical integration. The traditional rules of asset management continue to apply to corporate decisions about forward and backward integration. A higher degree of vertical integration can provide better operational control over a company's value chain, but must be weighed against additional capital and operational costs, the complexity of management, and the loss of flexibility that often occurs in companies with large legacy asset bases.

However, companies should also carefully consider three key questions to guide their strategic decisions about vertical integration.

Does owning or controlling assets and skills along the value chain significantly improve product performance and customer experience?
For companies like Apple, Netflix, Tesla, Ikea, Allbirds and Peloton, vertical integration has proven to be a key driver of superior business performance while creating competitive barriers.
Can skill building capital requirements be scaled to reflect a company's level of development?
Early-stage companies are often tied to capital, but have the advantage of being able to build and launch functions in small increments before committing to large-scale rollouts. For example, Peloton tiptoeed into retail, streaming video classes, and delivering white-gloved bicycles with small pilot operations in a single metropolitan area before expanding the scope of its operations internationally. In contrast, prior to launch, Ikea had to make nine-figure investments in building fulfillment centers, webstore infrastructures, and new operational processes in its multinational operations when it decided to significantly improve its e-commerce capabilities.
Are the products and services offered suitable for generating premium returns from superior product performance and customer satisfaction?
The investment required in vertical integration can only be justified if enough consumers recognize and are willing to pay premium prices for superior performance. Not all product categories meet this requirement, but market leaders in companies with strong personal and emotional customer loyalty – for example in the areas of health and wellness, automobiles, mobile technology and entertainment – have successfully used a high degree of vertical integration to build high-performing, profitable and resilient Companies.

Peloton answered each of the three questions with an emphatic yes! They chose not to hold on to knitting and the results speak for themselves.

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