Strategy Healthcare Jan 5, 2018

What’s Behind the Cur­rent Wave of Ver­ti­cal Integration?

From Ama­zon – Whole Foods to CVS – Aet­na, com­pa­nies are recon­fig­ur­ing for an uncer­tain future. Four strat­e­gy pro­fes­sors discuss.

Michael Meier

From the pro­posed CVS – Aet­na merg­er to Amazon’s pur­chase of Whole Foods, cor­po­ra­tions across the econ­o­my are ver­ti­cal­ly inte­grat­ing — that is, com­bin­ing stages or lay­ers of pro­duc­tion that have tra­di­tion­al­ly been separated. 

Fac­ul­ty from our strat­e­gy depart­ment dis­cuss the tac­tic, its evo­lu­tion, and its poten­tial to reshape indus­tries across the economy. 

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INSIGHT: Why are we see­ing this trend toward ver­ti­cal merg­ers at the moment? 

Craig Garth­waite: There is grow­ing uncer­tain­ty about some of the busi­ness mod­els in cer­tain indus­tries like health­care and enter­tain­ment, and how these indus­tries are going to gen­er­ate mon­ey from assets in the future. 

Meghan Busse: We’re pret­ty sure there’s going to be val­ue gen­er­at­ed by, say, health­care in the future. But which lay­er of the health­care sys­tem is going to be in the best posi­tion to cap­ture it: the phar­ma com­pa­nies, the insur­ers, the doc­tors, the hospitals? 

As you become more uncer­tain, com­pa­nies think, Well, okay. We don’t know which lay­er is going to be the valu­able lay­er, but if we own the whole thing from top to bot­tom, then whichev­er turns out to be the valu­able lay­er, we’ll be sure we’ve cap­tured it.” The only way to solve this uncer­tain­ty prob­lem is just to put all of the lay­ers of pro­duc­tion in the same entity. 

Aman­da Starc: The alter­na­tive would be con­tracts between each of the lay­ers. But you’re nev­er going to be able to write a con­tract that lets the ben­e­fits flow where they should. We know because we’ve tried. We’ve tried every vari­a­tion of this con­tract and none of them works par­tic­u­lar­ly well. Once you try to write the con­tract and you can’t, ver­ti­cal inte­gra­tion is the nat­ur­al next step. 

Garth­waite: It’s not just about which lay­er of today’s stack will mat­ter; it’s also about what the future of the stack could be. It’s going to require invest­ments from one cur­rent set of assets that pays off to anoth­er set of assets in a way that is not ful­ly clear. This guy at the bot­tom, he doesn’t want to make an invest­ment from which he might not cap­ture all of the ben­e­fits — and so he doesn’t.

This is, I think, in some ways like the CVS – Aet­na sto­ry. Think about the many clin­ics you see at CVS today. They’re designed to get you to buy phar­ma­ceu­ti­cals and cough med­i­cines and stuff like that in the store because that’s how CVS makes mon­ey. They don’t do a lot of pri­ma­ry care or pre­ven­ta­tive med­i­cine, which they might be pret­ty well posi­tioned to do, say for dia­bet­ics in between pri­ma­ry care doc­tor visits. 

Post-merg­er, CVS can have a nurse prac­ti­tion­er or even pri­ma­ry care physi­cians in stores, which is very low cost. CVS won’t get that much rev­enue from that, but it might stop patients from going to the hos­pi­tal, which is going to make Aet­na super hap­py. A merg­er like CVS – Aet­na would cre­ate the incen­tives where­by the firm is going to be more prof­itable if its cus­tomers are healthier. 

Starc: If you tried to write a con­tract between CVS and Aet­na, what does it look like? How do you define the set of cus­tomers? And then you need to include a met­ric — maybe some­thing like blood sug­ar. But even if you have all of these dia­bet­ics whose blood sug­ar is under con­trol, what you real­ly care about is whether or not they’re going to show up in a hospital. 

Garth­waite: Right. Peo­ple have mis­un­der­stood the argu­ment for sup­port­ing this merg­er — it is not say­ing this will work” to increase the prof­its of the com­bined firm , but it’s say­ing this is the sort of set of con­di­tions you would need for it to work.” 

INSIGHT: Are there times when we tend to see more ver­ti­cal inte­gra­tion than oth­ers, for exam­ple, when tra­di­tion­al busi­ness mod­els are being upended? 

Garth­waite: In a chang­ing busi­ness envi­ron­ment, inte­gra­tion seems to go in waves because the indus­try is not uncer­tain for one play­er. It’s uncer­tain for every­one in that indus­try. Every­one is try­ing to fig­ure out the right struc­ture to suc­ceed. You need a new set of assets and activ­i­ties to suc­ceed: some you’re going to buy, some you are going devel­op, and some that just aren’t that use­ful any­more you’re going to shed. 

Busse: There’s an exam­ple we talk about in our core strat­e­gy class that address­es exact­ly this: the rela­tion­ship between soft-drink pro­duc­ers and their bot­tlers. At Coca-Cola and Pep­si, con­cen­trate pro­duc­ers pro­duce the fla­vor and syrups and all of the brand­ing and nation­al adver­tis­ing, while sep­a­rate bot­tlers — not a part of those com­pa­nies — put the con­cen­trate in bot­tles and car­bon­ate it and deliv­er it and have it in the vend­ing machines. 

Over the decades, a very rich set of con­tracts evolved to deal with all of the poten­tial con­flicts and incen­tives in order to make this a work­able busi­ness model. 

But in the 1980s, con­cen­trate pro­duc­ers found them­selves deal­ing with all of these lit­tle fran­chised com­pa­nies that were too small to make the cap­i­tal invest­ments nec­es­sary to build a mod­ern, effi­cient bot­tling plant. What Coke and Pep­si did was buy up all of the lit­tle bot­tlers, ver­ti­cal­ly inte­grate, change the oper­a­tions of the bot­tlers, install the cap­i­tal — and then spin back out the bot­tling com­pa­nies. Hav­ing made the nec­es­sary adap­ta­tions to their bot­tlers, Coke and Pep­si could now go back to the for­mer sys­tem of incen­tive contracts. 

Fast for­ward 20 – 30 years. In the last decade or so, people’s tastes have been chang­ing. If you look at the per-capi­ta con­sump­tion of soda, it has flat­tened out as peo­ple have decid­ed it isn’t good to drink so much sug­ar. Now peo­ple want to drink oth­er things: sparkling water, teas, sport bev­er­ages…. In order for Coke and Pep­si to ensure peo­ple con­tin­ue to drink their brands, it’s going to take lots of invest­ments. Bot­tlers are going to have to run a much more com­pli­cat­ed pro­duc­tion process, with dif­fer­ent kinds of bot­tles and dif­fer­ent distribution. 

Again, the eco­nom­ics are chang­ing, so we have seen Coke and Pep­si buy up their bot­tlers again and spin them back out in a dif­fer­ent form. 

It’s not the role of gov­ern­ment to step in and stop a mis­guid­ed merg­er. Busi­ness­es should be allowed to make mis­takes. They may lose mon­ey. Cap­i­tal­ism is a messy busi­ness. — Craig Garthwaite

Starc: You can also imag­ine sce­nar­ios where ver­ti­cal inte­gra­tion does not work out near­ly as well. You can come up with lots of exam­ples of this in health­care. In the 1990s, a bunch of hos­pi­tals bought up a bunch of physi­cian groups. It turned out to be a bit of a dis­as­ter because you can buy up physi­cians all you want, but good luck telling doc­tors what to do. The two par­ties were finan­cial­ly inte­grat­ed but not par­tic­u­lar­ly clin­i­cal­ly inte­grat­ed. The hos­pi­tals end­ed up spin­ning off these physi­cian prac­tices later. 

You could imag­ine some­thing sim­i­lar hap­pen­ing in the CVS – Aet­na case. So while you can imag­ine a com­plete­ly rea­son­able rea­son they would want to rearrange the bound­aries of the firm, it may turn out that either the world changes in ways they didn’t expect, or their answer to the cor­rect expec­ta­tions was wrong. In both of those sit­u­a­tions, they may end up spin­ning them out because they real­ize they made a mistake. 

INSIGHT: What is the role of antitrust reg­u­la­tors in this environment? 

Garth­waite: It’s not the role of gov­ern­ment to step in and stop a mis­guid­ed merg­er. Busi­ness­es should be allowed to make mis­takes. They may lose mon­ey. Cap­i­tal­ism is a messy business. 

Government’s role in the antitrust sense is to make sure that con­sumers aren’t harmed from a lack of com­pe­ti­tion. They have a very spe­cif­ic, well-tai­lored, and impor­tant mis­sion to pro­tect competition. 

Mark McCareins: Ver­ti­cal merg­ers do not fit” the tra­di­tion­al hor­i­zon­tal-merg­er ana­lyt­i­cal frame­work used by the U.S. reg­u­la­to­ry author­i­ties. As such, the Fed­er­al Trade Com­mis­sion and Antitrust Divi­sion of the Depart­ment of Jus­tice are faced with pound­ing a square peg into a round hole. 

Cer­tain con­sumer-pro­tec­tion inter­ests appear fear­ful that such an amal­ga­ma­tion of pow­er and resources in relat­ed but not direct­ly com­pet­i­tive mar­kets could bode poor­ly for cus­tomers. Ver­ti­cal merg­ers along the lines of AT&T – Time Warn­er, Ama­zon – Whole Foods, or CVS – Aet­na could cre­ate enhanced bar­ri­ers to entry, reduce poten­tial entry, and dis­cour­age small­er rivals from com­pet­ing with the vast resources of entrenched firms. 

It must be not­ed, how­ev­er, that attempt­ing to draw a line between a good” ver­ti­cal merg­er and a bad” one using these types of met­rics is an extreme­ly slip­pery slope, espe­cial­ly when one con­sid­ers that one of the fun­da­men­tal tenets of antitrust pol­i­cy is that big­ness is not nec­es­sar­i­ly badness.” 

Busse: Exact­ly. Big­ness is not nec­es­sar­i­ly bad. The dis­tinc­tion is in how you got there and what you do with your size once you get there. 

Ama­zon got big because it offers a whole bunch of things in a real­ly con­ve­nient way. Ama­zon was not writ­ing exclu­sive con­tracts with pub­lish­ers where they tried to pre­vent Barnes and Noble from get­ting books. They haven’t been try­ing to buy out real estate licens­es to make it hard for retail book­stores to open, or write con­tracts with authors that pre­vent them from doing read­ings at local book­stores, or any of those kinds of restric­tive-of-com­pe­ti­tion things. They’ve just pro­vid­ed an offer­ing that lots and lots of peo­ple prefer. 

That’s very dif­fer­ent from what Stan­dard Oil did way back in the day where they real­ly did write con­tracts with rail­road com­pa­nies that would restrict them from being able to trans­port any­body else’s oil out of a par­tic­u­lar region, so small oil pro­duc­ers would go out of busi­ness and Stan­dard Oil could buy them up cheap. That tru­ly is anti-com­pet­i­tive, and there’s a rea­son why antitrust law tries to pre­vent it from happening. 

Starc: You could tell a sim­i­lar sto­ry in tech as well. The win­ners in tech offered the best prod­uct, con­sumers liked that prod­uct, and over time, they built up this net­work effect that became self-reinforcing. 

Busse: But there’s a point when you are so big and dom­i­nant that things you do can have anti­com­pet­i­tive effects — things that, if they were done by a small­er firm, wouldn’t have anti­com­pet­i­tive effects. 

Garth­waite: With great pow­er comes great responsibility. 

McCareins: Irre­spec­tive of whether ver­ti­cal merg­ers should be viewed with the same crit­i­cal eye that’s need­ed for merg­ers between direct com­peti­tors, the real ques­tion becomes, if such a view is adopt­ed, what econo­met­ric tools would antitrust reg­u­la­tors uti­lize to eval­u­ate ver­ti­cal mergers? 

Starc: The mar­ket-pow­er sto­ry is murki­er with a ver­ti­cal merg­er than a hor­i­zon­tal one, because one monop­oly brand store would not be able to extend its mar­ket pow­er by buy­ing the upstream firm. It’s not even imme­di­ate­ly obvi­ous that the merged enti­ty would lead to high­er prices con­di­tion­al on its mar­ket power. 

Busse: In a ver­ti­cal merg­er we have to look at what the com­pa­ny is going to do in terms of poten­tial­ly cre­at­ing greater val­ue and then look at whether that is going to put them at too great a risk of being in a posi­tion where they could behave in an anti­com­pet­i­tive way. 

INSIGHT: How has pub­lic atti­tude toward antitrust evolved over time? 

Garth­waite: Broad­ly speak­ing, you have seen a resur­gence among the Left of the belief that antitrust is a tool that should be used more wide­ly to cure a range of poten­tial ills. 

Starc: Take the AT&T – Time Warn­er merg­er. Many peo­ple are wor­ried that large media con­glom­er­ates need to pro­vide unbi­ased infor­ma­tion to con­sumers. And because we have such a strong pub­lic-pol­i­cy ratio­nale for them to pro­vide unbi­ased infor­ma­tion, we’re going to take antitrust action as one tool in a var­ied toolk­it to make sure these com­pa­nies remain independent. 

Fur­ther­more, when the incen­tives of the reg­u­la­tors are more close­ly tied to the peo­ple whom they are sup­posed to be reg­u­lat­ing than the gov­ern­ment or con­sumers. In this envi­ron­ment, firms that grow too big can engage in pub­lic pol­i­cy in ways that are to their ben­e­fit and to the ben­e­fit of their share­hold­ers rather than consumers. 

Still, this is not how antitrust enforce­ment is han­dled in this coun­try — and I think for good rea­son. You can be wor­ried about all of these things, but antitrust is not the right reg­u­la­to­ry lever to pull. The antitrust author­i­ty has clear instruc­tions: they’re sup­posed to be wor­ried about anti­com­pet­i­tive behav­ior that harms consumers. 

Garth­waite: There’s a dis­trust of large cor­po­ra­tions in the U.S. that’s dri­ving some of the public’s fear of big ver­ti­cal mergers. 

I think a lot of this con­cern is dri­ven by stag­nant wages and growth across the Unit­ed States. There is a greater share of income being enjoyed by the top 1 per­cent, and we’ve had com­pa­nies get­ting big­ger and health­care costs going up. All of this is hap­pen­ing togeth­er, so some slop­py rea­son­ing sug­gests that these must all be relat­ed. And they could be relat­ed. Many peo­ple have an intu­itive, vis­cer­al desire to say, We have a ham­mer we can use. We can try and break these com­pa­nies up. We’re angry at some­one. Let’s go ahead and do that.” But that’s a bad way of look­ing at antitrust. 

About the Writer

Fred Schmalz is the business editor of Kellogg Insight.

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