Commentary: Old Economy Or New, Vertical Empires Don't Work

For the likes of General Motors, Ford, and Lockheed Martin, it's a case of "been there, done that." They spent decades combining suppliers and manufacturing operations to cut costs. It turned out to be an expensive failure. Big manufacturers are now shedding everything but their core businesses, replacing the old model of vertical integration with a lean, mean approach based on outsourcing.

The New Economy may be repeating the mistakes of the old. With deals such as the proposed merger of Time Warner Inc. and America Online Inc., companies are rushing to assemble the same massive structures that manufacturers are dismantling. It is a trend they may ultimately regret.

Vertical integration makes sense only when a company can't be sure of getting the supplies or distribution channels it needs--as in the former Soviet Union. "If you have functioning markets, you don't need it," says F.M. Scherer, a professor of public policy at Harvard University's John F. Kennedy School of Government.

In free-market America, such integration is not only unnecessary but also costly. For starters, there's enormous pressure to buy in-house, even if the product is inferior or more expensive. When Ford Motor Co. spins off its Visteon Automotive Systems unit this summer, for example, Visteon will cut the prices it charges Ford by 5%. That change, based on a Ford-Visteon survey of industry prices, implies Ford overpaid by $850 million last year for Visteon parts.

CONFLICTS. To make matters worse, suppliers can lose customers when they become captive to a giant. In 1997, when Lockheed Martin proposed buying Northrop Grumman, Boeing threatened to dump Northrop Grumman as a supplier for fuselages and other components. Boeing had no interest in buying from a unit of archrival Lockheed Martin. Conversely, after GM spun off Delphi Automotive Systems Corp. last year, sales to GM remained stable, while orders from non-GM buyers jumped to 28% of revenue in the first quarter of 2000, from 18.3% in 1997.

Gobbling up the supply chain also creates political problems and ethical quandaries. Lockheed Martin execs found that the Pentagon and competitors suspected favoritism whenever the company threw business to its Sanders Electronics unit. So they have put Sanders on the block, in part to end the sniping.

Microsoft Corp. faces similar problems. Its grip on operating systems and applications, combined with its efforts to control distribution, disturbed enemies, who spurred the government's big antitrust case. Microsoft had far more adversaries than its operating-system dominance alone generated. While traditional trustbusters might have seen its move into applications as a problem, the worse offense was its operating-system monopoly. If Microsoft had 10% of the operating-system market, few would have cared about the rest.

Some New Economy companies have gotten the message. Brand-name electronics makers, such as Dell, Hewlett-Packard, and Nortel Networks, rely more and more on contract manufacturers to make their wares. And the brand-name companies don't want their contractors to become vertically integrated, either. "They recognize the inefficiencies of what they were, and they don't want that to be repeated," says Eric H. Miscoll, chief operating officer at consultants Technology Forecasters Inc.

DUST-UP. That hasn't stopped others from rushing to repeat the mistakes of the past--and the fallout is already beginning. Consider Time Warner's determination to link up content and distribution in one company, a recipe for difficult relations with other content providers. In early May, Time Warner and Walt Disney Co. got into a spat over how much Time Warner Cable would pay to carry Disney-owned ABC and two new cable channels. Before the dust settled, Time Warner blacked out Who Wants to Be a Millionaire? and other ABC programs from millions of American TV screens. The conflicts will only get worse when AOL buys Time Warner.

Disney's ownership of ABC could present certain problems as well. There will be pressure to run Disney's movies on ABC--even if CBS or another network might be willing to pay more for the privilege. And ABC could end up running the company's dogs at the expense of ratings. Only by spinning off ABC can Disney avoid these thorny dilemmas.

As the hard-won lessons of the Old Economy show, the rush to build massive multilevel empires is neither necessary nor particularly smart. The question is: How long will it take the New Economy companies to figure that out?

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