A recent news report ( BusinessLine , December 30) spoke of the Indian Railways wanting to set up a captive oil refinery to meet its requirements of diesel to power its locomotives. Whether it will do a better job of refining crude oil to produce diesel than it has demonstrated with moving cargo and passengers by rail is a moot point. Whatever be the truth in the proposition, one thing is clear. The Railways has always wanted to capture value that exists in the back end of the value creation process of transporting men and materials.
Some years ago, it considered a proposal to set up a coal-based power plant to produce electricity for its captive needs, as a good chunk of the route network is electrified. That the power distribution companies, largely state monopolies, have been gouging the Railways on the tariffs for electricity supplied is not in dispute. But does that automatically translate into a compelling case for venturing into power generation as a strategic business initiative? We wouldn’t really know because not much progress was made on the proposal.
Better control
But the development itself is an occasion to review the management literature on vertical integration (both forward and backward). From the welter of case studies on the subject, the following generalisations can be made.
Managers tend to eye opportunities for vertical integration with greater favour than horizontal integration (two competing players in a particular product market coming together). While both represent opportunities getting bigger (something managers always covet), vertical transactions are just that bit easier to put through as they pass the competition authority’s scrutiny more easily than those involving two competing firms’ proposal to merge.
Backward integration affords a business better control over access to inputs than would be the case if it was operated as a standalone entity. If the input in question is a scarce natural resource, it makes the case of vertically integrating with a raw material supplier all the more compelling. A good case in point is the rash of merger/ takeover proposals witnessed in the last decade or so, when power generation companies invested in coal mining businesses, or steel companies took over iron-ore producing entities. The reason is quite simple.
It is not easy to acquire control over these inputs and, without them, there’s a question mark against the survival of the parent business. When Tata Steel made a successful bid to acquire Corus (an Anglo-European steel conglomerate) the acquisition was viewed as necessary, not so much for the access it granted to the European Union market for steel, which was desirable in itself, but more because it enabled Tata Steel to control vast mining properties in Africa for coking coal and high-grade iron ore. What was, on the face of it, an instance of horizontal integration was perceived as a case of vertical integration.
Vertical or horizontal?
Considering the problems Tata Steel is facing in running Corus successfully as a steel unit, it might well be that the access to valuable iron-ore and coking coal concessions that came with the ownership of Corus may well tilt the scale for business historians to render their verdict on it as a successful example of vertical integration rather than horizontal integration between two competing steel producers.
In some instances, two adjacent value-creating activities are so integral to one another that vertical integration seems to most logical thing to do. A case in point is the value creation achieved in reducing iron ore into molten metal and its subsequent conversion into steel. It is impossible to conceive of these two activities as anything but an integral whole, so much so that the case for vertical integration stands already established.
Of course, here again, India offers a unique exception to the golden rule. In the decades following the attainment of freedom and the country adopting a mixed socialist cum capitalist model of economic development, licences for setting up integrated steel plants were hard to come by. sOn the other hand, licences to set up re-rolling mills were comparatively easier to get, given their lower capital intensity. You thus had an absurd situation where molten steel was allowed to be solidified as an ingot and shipped to re-rolling mills which would then re-heat it, make steel sheets out of it and sell it to the consumers. The more efficient producers of steel abroad were not much of a threat to this inefficient process of making steel in a usable form, as high Customs duties effectively knocked them out of contention.
Not always a good idea
Just as some businesses are strategically made for one another as an integrated operation, the exact opposite is also true. The airline industry is a good example. Airlines need aircraft as inputs to be able to run their business. But it would be disastrous for an airline company to backward integrate itself to be engaged in aircraft manufacture as well. The technological complexities of the two businesses are so vastly different as to rule them out as made for each other in the strategic management sphere. As a general rule, if the input consists of a lumpy, one-time acquisition to be repeatedly used in business, then the value chain acquires a completely different complexion than the plain vanilla manufacturing operation of a business.
A strategic case can be made for backward integration if the nature of competition across two adjacent activities in the value chain is markedly different. Reliance Industries demonstrated this throughout the 1980s in the most telling manner possible. Until the 1970s, Reliance was one of 100 other players in the synthetic yarn and textiles business. True, its capacity for managing the regulatory environment did give it some advantage in sourcing its requirement of imported raw material over its rivals in the fibre and textile business. But it was nowhere near as profitable as it is today. Nor could it have grown to this size by continuing to be engaged in the yarn and textile business.
The Reliance group’s decisive moment for supremacy came when it successfully implemented a project for the manufacture of purified terephthalic acid (PTA), a raw material for making polyester staple fibre which, in turn, goes into the making of yarn and other downstream products.
The Reliance story
There were no domestic producers of PTA until Reliance entered the scene. As a monopoly producer of PTA, aided in no small measure by the Government tweaking the duty structure for imported PTA, it shifted the pricing power in favour of Reliance, to the disadvantage of innumerable small players producing synthetic yarn and textiles. From here on, a succession of backward integration moves across a range of petrochemical products helped make Reliance a giant on the Indian manufacturing landscape.
While Reliance Industries is a shining example of a successfully integrated company in the oil and petrochemical sector, not all fully integrated businesses have emerged successful. IBM, Digital Equipment Corporation or a Burroughs Corporation did possess well integrated companies in the IT industry. Two have sunk into oblivion while the third is a struggling giant. To the contrary, Apple, with no backward linkages, has emerged as the most successful company in global history.
Clearly, there is no one-size-fits-all in strategic management.