Learning to Survive and When to Move Up and Down the Value Chain

Relevant Concepts from Christensen and Porter 

Clayton Christensen says incumbents can normally address sustaining product improvements, even product breakthroughs by new entrants, by simply co-opting or acquiring the entrant's business. See The Innovator’s Solution, by Clayton Christensen and Michael Raynor (Harvard Business School Publishing Corporation, 2003). If a company is acquired only for its resources (people, products, technology, or market position) then it can be safely integrated into the acquiring company's business. Id. If a company is also acquired for its processes and values -- its ways of making decisions, getting things done in a timely and cost effective way, and company culture/priorities -- then it should be operated as a separate entity since integration may destroy the processes and priorities that make the company successful. Id.

Christensen also says it makes sense for a company to move to adjacent links of the value chain when the company's link becomes too commoditized or unprofitable. Christensen says companies should try and skate to where the money will be, or those chain links that aren't yet good enough and therefore aren't yet commoditized and low margin. Id.

Blending a little of Christensen with Michael Porter, Porter says companies should compete to be unique. See Concepts page and discussion of Michael Porter and post titled Acquisitions, Rivalry, and Strategic Trade-Offs. So Porter might say it makes sense to acquire an adjacent link of the value chain when the acquisition gives the company a more unique set of activities and improves activity fit, making the company's value chain link(s) more defensible and harder to duplicate.

Costs and Benefits of Value Chain Moves

It's important to consider the costs and benefits of any move to an adjacent value chain link. When a component manufacturer, for example, moves up the value chain and also starts assembling final products that incorporate the component, it may lose component business from the final assemblers who were previously its customers. This outcome is less likely if the component is priced attractively, but it's still a risk -- companies don't like helping or giving business to competitors. This is why Samsung has started losing some of Apple's semiconductor business. Samsung went from making smartphone semiconductors to also making smartphones, competing more and more directly with Apple, one of Samsung's semiconductor customers. Apple is now ordering more chip components from TSMC, which is a pure chip foundry. TSMC's willingness to stay squarely in place, in its component manufacturing value chain link, has become one of its key competitive advantages.

There's also the risk of a final assembler moving down the value chain and entering the component manufacturing business. This outcome is unlikely so long as the component business is lower margin -- and therefore less attractive -- than the final assembly business.

As this discussion illustrates, any time a company moves into new parts of the value chain it creates new rivals and new competitive pressures. This can make partnerships more difficult. It's easy for companies in different parts of the value chain to partner (e.g., Apple and TSMC). Partnering is more difficult when companies share one or more value chain links (e.g., Apple and Samsung).

When a company moves to an adjacent value chain link, it must consider the competitive response of companies in that adjacent link, and whether damage from this response outweighs the benefit of higher margins, more unique activities, and/or better activity fit.

I'd argue that component makers with low cost business structures are usually well-positioned to move up the value chain, even if it means they might lose business from final assemblers that buy their products. That's because a component maker moving up the chain, operating with a low cost business structure, has already experienced intense competition at the component level and is well-prepared to deal with competition from final assemblers, even if it means losing some component orders.

A component maker moving into a higher margin assembly business can also profitably sell the final product to end users at a lower price than unintegrated final assemblers. That's because the component maker can get the relevant part at cost, while the unintegrated final assembler must buy the part at a marked up price from a separate supplier. This phenomenon gives component makers moving into final assembly a pricing advantage -- their cost of goods sold is lower, meaning they can sell the final assembled product at a lower, more competitive price.

Acquiring at an Attractive Price

From an investing perspective, one powerful rationale for making an investment (or acquisition) is when the upside is large and the downside is small, or what investor Mohnish Pabrai calls "heads I win, tails I don't lose very much." See The Dhando Investor, by Mohnish Pabrai (John Wiley & Sons, Inc., 2007). Pabrai believes the markets often undervalue businesses with uncertain future outcomes. For this reason he looks for businesses with:

(1) high uncertainty in terms of possible future outcomes (which often creates an undervalued situation);

(2) high returns if things go well; and

(3) minimal losses if things go poorly.

Id. Pabrai especially likes businesses with low cost operating models, which is consistent with Porter's comments on generic strategies. Porter believes there are four viable generic strategies: differentiated and targeting a broad market; differentiated and targeting a niche market; low cost and targeting a broad market; and low cost and targeting a niche market. See Concepts page and discussion of Michael Porter. Competitors typically don't want to get stuck in the middle, selling an undifferentiated product that's not low cost to the middle of the market. That's because they lose business to: (1) low cost, undifferentiated competitors who can beat them on price; and (2) high end, differentiated competitors who can beat them on quality, service, and product features.

If you accept Pabrai's reasoning, it makes a lot of sense for large incumbents to acquire threatening new entrants as early as possible, before the entrant grows prohibitively expensive. Uncertainty over a new entrant's future can help keep the acquisition price down.

Acquisition Criteria

In light of the principles above, acquisitions can be evaluated in terms of the following criteria:

(1) Does the acquisition move the company into an adjacent part of the value chain that isn't yet good enough and therefore isn't yet commoditized and low margin? Do the margin benefits outweigh any damage to the company's existing business?

(2) Is the acquisition needed to defend/strengthen the company's existing link(s) in the value chain because:

(a) the entrant has a breakthrough, sustaining technical improvement/innovation (which might only require a resource acquisition followed by integration of the acquired company); or

(b) the entrant has a breakthrough, disruptive business model (which might require acquisition of the company's resources, processes, and values and operation of the company as a separate entity).

(3) Does the acquisition strengthen the company's existing link(s) in the value chain by leading to a more unique set of activities with better fit across activities? See post titled Acquisitions, Rivalry, and Strategic Trade-Offs.

(4) Can the company be acquired cheaply enough -- due to future uncertainty -- that the financial upside is large while the financial downside is small?

Western Digital

Looking at a real world example, Western Digital ("WD") seems to satisfy a lot of the criteria discussed above:

(1) WD acquired Hitachi Global Storage Technologies ("HGST") to get a better foothold in a sustaining technology, enterprise flash storage. HGST subsequently acquired sTec, another enterprise flash storage company. These moves strengthened and defended WD's existing value chain link, hard drive manufacturing/storage.

(2) HGST recently acquired Skyera, which makes all-flash arrays and accompanying software systems for enterprise storage, effectively moving into an adjacent value chain link. All-flash arrays and related software should provide WD/HGST with a higher margin business than the manufacture of hard drives and flash memory. This acquisition also seems to give WD/HGST a more unique set of activities with the possibility of good fit between Skyera's activities, assembling all-flash arrays, and WD/HGST's activities, manufacturing flash memory and hard drives.

The caveat here is that WD is now in direct competition with some of its former customers, companies like Dell and EMC. Hopefully WD has weighed the costs and benefits of this kind of competition, ultimately concluding that the benefits of higher margins and more unique, tightly integrated activities outweigh lost partnerships and component business.

Because WD/HGST makes one of the key components -- flash memory -- used in Skyera (now HGST) all-flash arrays, its cost of goods sold for all-flash arrays will probably be lower than the cost of goods sold for incumbents like Dell and EMC, giving WD/HGST an all-flash array pricing advantage and putting them in a good competitive position.

(3) WD/HGST has positioned itself as a low cost manufacturer of tiered storage for a broad market, selling low cost hard drives and flash memory to consumers and enterprises. This is one of Michael Porter's four viable generic strategies.

How Competition Teaches

There's a great blog post by Professor Bill Barnett, who teaches at Stanford University's graduate business school. In a post titled The Red Queen Barnett argues that competition teaches and "causes organizations to learn." Barnett says that over time an organization facing rivalry will outperform and out-innovate a monopolist, because an organization with strong rivals must continue improving and innovating to survive.

In this sense, rivalry should make at least a few industry competitors stronger over time (i.e., the ones that survive). This, in turn, may make it more difficult for new entrants to upend the industry with a sustaining technological improvement or disruptive low end or new market product/service. Western Digital and Seagate, for example, have engaged in years of brutal competition in the hard drive industry -- they're now the only companies left making hard drives (a very attractive duopoly). Intense competition has taught them how to survive, both through low cost business structures and through strategic acquisitions of threatening new entrants. Industry rivalry has sharpened Western Digital and Seagate's strategic knowledge and operational skills.

The caveat to Barnett's article would be that industry rivalry isn't good if a company lacks the knowledge and ability needed to adapt and survive (consistent with Porter's comments on the destructive impact of too much industry rivalry).

The author owns stock shares of Apple and Western Digital.