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“Act Vertical” vs. “Go Extinct” Retailers - Part 1
“Act Vertical” vs. “Go Extinct” Retailers - Part 1
March 30 2009
In over a decade of covering the enterprise application space, I’ve repeatedly lauded and advised
(i.e., someone’s proven expertise in some particular industry and market segment
), but not that much vertical integration
. My beliefs were recently confirmed by what I learned while pursuing my
APICS CSCP (Certified Supply Chain Professional)
Namely, Module One of the
APICS CSCP Learning System
, entitled “Supply Chain Management Fundamentals” teaches that companies have generally pursued one of the following two types of
supply chain management (SCM
): either vertical or lateral (also known as horizontal) integration.
Vertical (supply chain) integration
refers to the practice of bringing the entire supply chain inside a single organization.
, or the ownership of many or all the parts of a supply chain, has been around longer than the term
By bringing many supply chain activities in-house and putting them under centralized corporate management, vertical integration solves the problem of who will design, plan, execute, monitor, and control supply chain activities.
In other words, the primary benefit of vertical integration is control. For instance, a department or wholly owned subsidiary with no independent presence in the marketplace cannot make a deal with competitors (e.g., to sell its components or services at a higher price or faster). Divisional operations are completely visible to the parent company (at least in theory) and can be synchronized with other company functions by directives from the top. The overarching management controls the division’s schedules, workforce policies, locations, amounts produced, and all other aspects of its business.
The Way We Were
One often-cited example of vertical integration is the automobile company built by
, who frequently receives mention as an especially successful avatar of this approach. In the early days of the automotive industry,
pursued a strategy of owning and controlling as many links in the
supply chain as possible, from rubber plantations to supply raw material for tires right on through the dealerships that distributed cars to the public. In an attempt to create a self-sufficient enterprise, Ford even owned iron ore mines, steel mills, and a fleet of ships as well as the manufacturing plants and showrooms that built and distributed the cars bearing his name (and, eventually, the brands of
In the retail arena, vertical integration was pioneered by such retail brands as
The Limited (LTD
Recreational Equipment Inc. (REI
. These merchants wanted far more control over the products they placed on their shelves, racks, and bins. To gain this control, they moved “upstream” their supply chain into collaborative product development and, in some cases, even manufacturing.
This model actually fueled the ascent of
in the early 1980s, when its new CEO at the time,
Millard “Mickey” S. Drexler (subsequently the chairman of
, made a major strategic shift. The decision was to move away from being a merchant of
into a retailer that would sell only one brand of a broader line of products: its own. Over the next 20 years (1983 to 2003), Gap’s revenue soared more than 30-fold to nearly US$16 billion, before flattening out the last several years.
As a peek preview of what will come later in this blog series, retailers that have embraced a modified vertical business model are racing ahead of competitors that have not, or those that are moving slowly to become more vertical (of sort). In fact, the spoils of acting vertical have attracted wholesalers and manufacturers.
Consider the wholesaler
, which began in 1899 as a Pennsylvania clothing manufacturer. Now a US$6.2 billion company, VF opened its first retail outlets in 1970 as a way to dispose of discontinued lines. Nearly 20 percent of VF’s revenue today is from retailing, a percentage that could increase if the firm’s plans to add new stores to its base of more than 500 are carried through.
Apple Computer Inc.
has moved to act vertically as well, jumping into the retailing business in 2001. Today the retail part of
's business is substantial: over US$4 billion, or 17 percent of the company’s total revenue. But we will revisit these two (and several more) buoyant retailers later.
Vertical Integration Going
While some form of vertical integration still persists in some companies (e.g., wireless phone companies may still purchase [although not manufacture] the phones, stock them at retail outlets, sell them, provide coverage, and handle warranty service), this business model has generally gone out of fashion as corporations became vaster in scale and global supply chains became quite a bit longer. It is indeed difficult for one corporation to garner the expertise needed to excel in all elements of the supply chain.
Thus, corporations in West Europe and North America, especially, have turned instead to
outsourcing those aspects of their business in which they judge themselves to be least effective and competent
. The complexity and expense of managing all those diverse activities drives top management to sell off assets not directly contributing to the core business. Japanese companies, on the other hand, favor an intermediate form of integration called
in which suppliers and customers are not completely independent but instead own significant stakes in one another.
Lateral supply chain integration has replaced vertical integration as the favored approach to managing the myriad activities in the contemporary supply chain. The
lateral (horizontal) integration
is presumed in most supply chain operations, and horizontal chains are now the way of the world and, therefore, the major focus of supply chain theory and practice.
The "Big Three" (currently languishing) United States (US) auto companies
(which now own significant stakes in, or are owned by, foreign automakers) have all divested themselves of their in-house component suppliers.
Ford Motor Company
was no exception to this trend since it underwent a radical transformation of its supply chain at the turn of the 21st century. Like the other two major fellow “Motown” automakers, Ford divested itself of the production of many components, as
spun off its
(short for MOtor PARts) division
General Motors (GM)
turned its component supplier loose to become
Hence, it appears that the days of being totally self-sufficient and capable in today's world of high technology and virtual engineering and manufacturing are over. Rather than bringing all the functions inside the walls of one corporation, large manufacturers and service providers are now more likely to adopt a lateral supply chain strategy.
In a lateral supply chain constellation, separately owned firms focus on core competencies such as extraction, harvesting, production, or distribution, and deal with each other through discrete transactions or longer-term contracts. Among the reasons for relying on a lateral supply chain, the following three stand out:
economies of scale
economies of scope
-- No matter how large the corporation, its internal supply chain functions lack economies of scale when compared with the potential capacity and acumen of an independent provider of the same product or service.
To improve business focus and expertise -- Vertical integration, in a globally competitive market, multiplies the complexity of managing disparate businesses spread across international borders, time zones, and oceans. An independent company that focuses entirely on its particular business can develop more expertise than an in-house department, leading to more attractive pricing, higher quality, or both. Both the spun off (outsourced) function and the parent firm benefit from a cleaner focus on what they do best after they part company.
Because it is possible today -- With the advent of advanced, nearly instantaneous communication technology (i.e., whereby information can be shared simultaneously by videoconference or in chat rooms around the globe), many of the traditional barriers to doing business at a distance have been falling away. As the entire globe becomes a virtual marketplace, it makes sense to deal with already established companies that know their local markets.
In addition to
many possible outsourcing examples in China or India
, a lesser known fact is that many apparel companies in Europe work through Dutch logistics centers to take advantage of Holland's central location. Therefore, a number of specialized firms have sprung up there with well-developed capabilities in handling both the distribution and return of clothing.
Lateral Supply Chains: Not without Challenges
Despite the outlined potential attractions of the lateral chain, however, the fact remains that synchronizing the activities of a network of independent firms can be enormously challenging. Once corporate ownership abandons the idea of vertical integration and turns instead to outsourcing various activities, it loses control of those aspects in the multi-tiered supply chain. This loss of control is because the company now has to deal with separately owned independent companies as suppliers or customers.
What each supply chain member gains in scale, scope, and focus, it may lose in ability to see and understand the larger supply chain processes or care about them. It is not easy to capture the complexity of a global supply network with multiple connections around the world and information shared on sprawling networks connected all along the chain.
The abovementioned benefit of economy of scale and scope assumes, of course, that the independent provider supplies all of the needs of the original corporation and other customers as well. In that case, the supplier is most likely dealing directly with companies that compete with one another for the same business. The gain in scale may thus come at a price in confidentiality (although lack of confidentiality cuts both ways).
So, What’s the Point Here?
National Retail Federation (NRF) Annual Convention & EXPO 2009
(also known as the Retail Big Show
) in January in New York City has helped me realize how some innovative retailers have modified the abovementioned evolutionary trend toward more outsourcing and the building of electronically linked virtual enterprises. The event was a bit of a surprise for me due to its (unexpectedly) upbeat vibe and decent attendance (although smaller than previous years). After so much negative news from national and cable TV channels at the time, following on the dismal past holiday season, I expected a much more somber mood indeed.
Believe it or not, this economy has actually made retailers (rather than consumers) spend, which may seem counterintuitive for most people except for informed SCM professionals.
Upbeat recent results of leading Retail SCM applications providers like
might indicate that retailers are buying software these days in spite of the economic downturn (and given that they were not that crazy about packaged software even during better days).
Compared to all of a retailer’s current IT investments, these companies are only moving forward with investments that offer a direct payback. There has been investing in SCM applications that have a defined
return on investment (ROI
) that is attractive to retailers, who now need to be hyperefficient.
Kurt Salmon Associates (KSA
), the leading global management consulting firm specializing in the retail and consumer goods industries, the historic relationship between retailers and their customers has changed dramatically over the past decade. The mounting disappearance of many retail stores and whole chains testifies to the fact that a growing number of retailers have failed to respond to a new set of customer expectations and growing competition for
share of wallet (SoW)
The shakeout began long before the current economic downturn, and it will most likely extend long after the economy rebounds. The number of retail bankruptcies and mergers began accelerating in 2002, long before the latest recession started. In particular, the sad state of the retail sector’s affairs in 2007 was illustrated by about 1,500 mergers and 300 retail bankruptcies in the US, according to
bankruptcy database of retailers, including Internet retailers.
Moreover, for 225 publicly held US retailers between 1998 and 2007, 60 percent could only generate single-digit annual earnings growth, while 15 percent had declines in annual earnings growth. Hence, over the last 10 years, the number of department store chains has shrunken from 27 to 7.
Stores have been especially vulnerable given an excess of retail space in the US (up 31 percent per capita over the last 25 years in the 54 biggest markets) and diminishing growth in sales per square foot at many retailers, even at seemingly recession-proof
Wal-Mart Stores Inc
. Despite the first annual drop in 20 years in occupied retail space, the retail construction boom this decade has left the US with too many stores competing for the same customers.
The bad news goes on and on,
with with well-known brands such as
KB Toys, Linens 'N Things, Circuit City
being the latest casualties
. Namely, in addition to globalization implications, retailers and their trading partners have to combat price pressures from competitor bankruptcies and deal with so much potential excess inventory.
KSA’s research finds that US apparel retailers alone lose $64 billion annually on markdowns, and some of them spend even a half of their planning resources on managing markdowns. Moreover, retailers have to diligently assess the financial health of trading partners (to ensure equitable trading), deal with current tight credit policies and (un)availability, and properly use
behavior) as key factors in planning and forecasting.
Driving the abovementioned gloomy stats is the fact that customers have many more places to buy the same products. Indeed, there is an overabundance of
“brick and mortar”
retailers selling the same items from the same brands. On top of that, there is a proliferation of online retailers, and
online auction sites that have made a large and growing market for used goods disposition
As a result, the traditional retailing model of being just a purveyor of national product brands (and their knockoffs) is failing to inspire the customer to purchase, at least repeatedly. Customers demand much more of the retailers they choose to deal with in terms of products and brands they can’t get anywhere else.
Consumers also value their ability to shape those products to meet their needs, and much different ways of interacting with the retailer, i.e., the customer’s retail experience. Retailers (possibly even the discounters and stores that compete merely on price and convenience) that ignore these trend shifts risk sliding into irrelevance with obsolete business models.
No Doom-and-Gloom for “Act Vertical” Retailers
But this state of retailers’ despondency is not necessarily across-the-board. One of the most enlightening presentations at the NRF event was by
, and can be
. In March 2008, KSA launched research that used quantitative and qualitative methods to deeply explore the trend of vertical integration in retailing.
On the quantitative side, KSA conducted an extensive 28-question survey with 101 retailers (all of which had more than $500 million in annual revenue). On the qualitative side, the firm conducted in-depth case studies on 10 retailers, mostly through on-site and phone interviews with a range of executives at each retailer. A couple of case studies came from extensive literature searches and retail executives’ discussions with KSA subject-matter experts.
In a nutshell, over the last decade consumers have increasingly embraced an eclectic group of retailers that have become sort of vertically integrated. Even during these tough times, such retailers can boast with an operating margin of over 20 percent, and KSA ascertains the market opportunity of US$ 2 billion annually. This select group of retailers have significantly outperformed the market on a number of
key performance indicators (KPI’s)
as follows: revenue growth,
operating profit margins
, and inventory
return on assets (ROA
), among others.
The subsequent parts of this blog series will examine a number of retailers that have recognized this paradigm shift. They have developed a new operating model to differentiate themselves and deliver much greater value to their customers and shareholders. This operating model has been used by a small number of retailers including
. Each company has grown rapidly despite the shakeout of retailers in its segments.
KSA refers to this operating model
for two reasons. First, these retailers have realized the need to become serious product innovators and not just merchants and peddlers. Accordingly, they collaborate on the front-end (upstream) of the supply chain with their customers to design and develop a number of compelling products with their brands on them (or national brand exclusives in some cases) for everything they sell.
However, they are not manufacturing these products, as is the case with true vertical integration. On the back-end (upstream) of the supply chain, they are working in a highly collaborative fashion with a smaller number of certified manufacturers. These retailers have control over quality without necessarily owning manufacturing, and hence the “acting vertical” moniker.
Till then, what are your thoughts and comments in this regard? What are your experiences in dealing with the abovementioned retailers? What
retail software applications
do you think can help these companies in their “act vertical” efforts?
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