Peloton announced blowout earnings last week, and has joined an elite club that includes Apple, Netflix and Tesla. These companies not only delight their customers and create enormous shareholder value, but they also operate a highly vertically integrated enterprise. The success of these companies is rewriting some outdated rules on what drives effective business strategy.
If you want to thrive in today’s market, it’s worth understanding exactly what’s behind these companies’ growth … and how different it is from the way companies used to think.
A quarter-century ago, in their widely acclaimed book Competing For The Future, C. K. Prahalad and Gary Hamel argued that market leaders owe their success to an identifiable set of core capabilities, which allow them to outperform competitors. These capabilities could be in engineering, product design, manufacturing, supply chain management or marketing prowess, enabling their masters to achieve market leadership in distinctive ways.
For example, through the lens of capability-driven strategy, Walmart exploited its expertise in global sourcing and supply chain management to build a formidable competitive advantage in wide product selection at everyday low prices. Toyota, meanwhile, achieved market leadership by excelling in product engineering and efficient, high-quality manufacturing.
To grow big, the theory went, market leaders should heavily reinvest in what they’re best at — and outsource non-core business functions to third parties. Accordingly, Walmart didn’t seek to design or manufacture its own products and Toyota left retailing operations 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. It’s why, when Apple first announced plans to open company-owned stores, and Amazon began designing its own consumer electronics, the pundits of the business world piled on. In 2001, Bloomberg published what turned out to be a spectacularly misguided commentary titled “Sorry, Steve [Jobs]: Here’s Why Apple Stores Won’t Work.” And Amazon was often pilloried after launching its first generation Kindle for what was considered a hubristic, ill-fated venture into the realm of consumer electronics design where the company didn’t belong.
What did these critics miss? They were attached to this “capability-driven strategy” — the idea that companies should focus exclusively on what they’re best at. And they didn’t realize that the idea was flawed, and getting old.
For starters, they failed to recognize that capability-driven strategy often encourages mature companies to cling to outdated skills and assets that limit growth opportunities. Stick-to-your-knitting managerial mindsets instinctively resist disruptive changes that may cannibalize current sales, and they tend to frame strategic choices inappropriately. Instead of focusing primarily on how current assets can be exploited to increase near-term sales, managers should also be asking how and where consumers want to be served, and what capabilities are needed to best reach them? For example, while Walmart and IKEA have long been market leaders in big-box retailing, both were late — and are now playing catch-up!—with ecommerce capabilities.
Meanwhile, a new generation of companies were much more open earlier in their development to vertical integration — building and mastering every part of the market themselves. Native ecommerce startups like Warby Parker, for example, recognized the potential to expand their market reach through physical retailing. Then they built the requisite omnichannel retailing skills internally.
Startups should be particularly open to building vertically integrated capabilities when appropriate as soon as funding capacity and management talent and bandwidth permits, for three reasons.
First, at inception, startups often don’t have a deep reservoir of expertise in any core competencies. There are no assets or manager egos to protect and no sales to cannibalize. Finding the right mechanisms to achieve target market growth are paramount drivers of early stage venture strategy.
Second, for highly innovative ventures, the requisite product design, manufacturing and distribution skills may simply not be available from third-party providers. That forces entrants to build their own capabilities to support category-defining new approaches. This was the case with both Tesla and Allbirds, who of necessity were deeply involved in product design, global supply chain management, manufacturing and new retailing formats to launch their game-changing products.
Finally, and perhaps most importantly, vertical integration can give companies more control over delivering superior products and better experiences at every customer touchpoint. For example, it is now generally recognized that Apple’s tight control over hardware and software design, as well as operating its own company stores, have contributed to superior product performance, customer satisfaction, and price realization, more than offsetting the increased costs and complexity of managing a vertically integrated enterprise.
Peloton provides another illustrative case in point.
In 2011, John Foley conjured up an idea for a “connected fitness” company that would ultimately require expertise in hardware design, software development, professional video production, fitness studio operations, and physical retailing, none of which matched the founder’s professional background. The initial plan was to rush a minimum viable product to market by fitting Peloton’s own software and electronics to existing bicycle and tablet computers, enabling its products to monitor real-time rider performance and stream online spin classes. But at this and several other pivotal milestones along the way, Foley and his co-founders decided that the company would be better off developing its own products and internal capabilities, rather than relying on third party providers.
Among the capabilities it created itself:
- After concluding that existing bicycles and tablets were not suitable for the company’s intended use, Peloton designed its own custom bike from the ground up, with entirely proprietary hardware and software.
- Peloton recruited and trained its own instructors, rather than partnering with existing fitness boutiques
- Peloton deployed its own state-of-the-art production studios and fitness boutiques, rather than tapping into existing facilities
- Peloton developed its own network of retail outlets to complement its ecommerce channel, rather than selling through existing stores
- Peloton backward integrated into company-owned hardware manufacturing after initially relying on contract manufacturers
- Peloton developed its own “white glove” delivery/installation service, rather than relying solely on third party logistics providers
This sequence of strategic decisions unquestionably increased Peloton’s capital requirements, which Foley acknowledges severely stressed the company during its early development. But as evidence mounted that Peloton was delivering a superior product and customer experience to a rapidly growing base of enthusiastic and loyal subscribers, the company was able to raise nearly $1 billion in private capital.
In its public offering prospectus filed last summer, Peloton described the scope of its vertically integrated operations as follows: We are a technology media software product experience fitness design retail apparel logistics company.
Peloton IPO’d in September, 2019. By mid-2020, it was serving over one million subscribers in four countries and generating over $1.8 billion in annual revenue with strong positive operating cash flow. As a testament to the success of its vertical integration strategy, Peloton currently achieves higher hardware gross profit margins (45%), higher customer satisfaction (93 NPS) scores and higher customer retention rates (92%) than Apple or Tesla.
Peloton’s success is not to meant to be a blanket endorsement for high levels of vertical integration. The traditional rules of asset management still apply to corporate decisions on forward and backward integration. Higher levels of vertical integration can provide greater operational control across a company’s value chain, but must be weighed against added investment and operating expenses, management complexity and the loss of flexibility often found in companies with large legacy asset bases.
But companies should also give careful consideration to three pivotal questions to guide their strategic decisions on vertical integration.
- Does owning or controlling assets and capabilities across the value chain significantly improve product performance and customer experiences?
For companies like Apple, Netflix, Tesla, Ikea, Allbirds, and Peloton, vertical integration has proven to be a key driver of superior company performance, while also building barriers to competition.
- Can the requirements for capability-building capital be scaled to reflect a company’s stage of development?
While early stage ventures are often strapped for capital, they have the advantage of being able to build and launch capabilities in small increments, before committing to large scale rollouts. For example, Peloton tiptoed into retailing, streaming video classes, and white-glove bicycle delivery with small pilot operations in a single metropolitan area before expanding the scope of its operations internationally. In contrast, when Ikea decided to significantly upgrade its ecommerce capabilities, it faced nine-figure investments to build fulfillment centers, webstore infrastructure and new operating processes across its multinational operations prior to launch.
- Are the products and services offered conducive to generating premium returns from superior product performance and customer satisfaction?
The required investments 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 businesses with a strong personal and emotive connection to customers — for example in health and wellness, automobiles, mobile technology, and entertainment — have successfully exploited high levels of vertical integration to build powerfully advantaged, profitable and resilient enterprises.
Peloton answered each of the three questions with an emphatic yes! They chose not to stick to their knitting, and the results speak for themselves.