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This writing is in response to the article recently written by SA contributor Ashraf Eassa titled Samsung is Apple's Worst Nightmare. In the article Ashraf argues that Apple (AAPL) should suspend their stock repurchase plan and acquire Sharp Corporation (OTCPK:SHCAY), GlobalFoundries, and Micron Technology Inc. (MU) to achieve partial backward vertical integration in their supply chain. He argues that without matching Samsung's (OTC:SSNLF) backwardly integrated structure, Apple stands little chance competing over the long run. The purpose of this article is to provide a background on vertical integration and show it is not always cost effective. Additionally, I will outline several market circumstances when vertical integration may make sense and analyze whether the display, foundry, or DRAM/NAND markets fall into these circumstances.

Vertical Merger

In a vertical merger, the acquirer buys another company in the same production chain, for example, a supplier or a distributor. In addition to cost savings, a vertical merger may provide greater control over the production process in terms of quality or procurement of resources or greater control over the distribution of the acquirers finished goods. Vertical mergers come in two types, a forward integration and a backward integration. A forward integration occurs when an acquiring company purchases a firm later in the supply chain. An example of this type of integration would be Apple purchasing a retail outlet that sells its products, for example Best Buy (BBY). A backward integration occurs when an acquiring company purchases a firm earlier in the supply chain. An example of this type of integration would be Apple purchasing a parts supplier like Micron Technology Inc.

When to Vertically Integrate

Vertical integration can be a highly important strategy, but it is notoriously difficult to implement successfully and when it turns out to be the wrong strategy, costly to fix.2 In their 1993 article titled When and When Not to Vertically Integrate, McKinsey&Company consultants John Stuckey and David White developed a framework to help managers decide when it is cost effective to vertically integrate. The framework is fairly straight forward in that it asks managers to weigh the costs and benefits of vertical integration against each other. Exhibit 1 lists the kinds of costs, risks, and coordination issues that should be weighed in the integration decision.

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The tough part is that these criteria are often at odds with each other. Vertical integration typically reduces some risks and transaction costs, but it requires heavy setup costs, and its coordination effectiveness is often dubious.3 In Apple's case, the relevant costs of a vertical merger would be the huge amount of capital needed to make the acquisition and the limits the acquisition puts around switching between new supply technologies. Benefits include potentially higher margins, better control of necessary supplies, and more quality control.

Reasons to Consider Vertical Integration

Despite the substantial costs of vertical integration there are certain market circumstances where the benefits may outweigh the costs. Stuckey and White outline four reasons a firm should consider vertically integrating, three of which are applicable to backward integration. The first and most important reason is vertical market failure. A vertical market failure occurs in a market structure where there are large coordination issues between buyers and sellers. Transactions between firms in this type of structure are risky, and contracts designed to overcome these risks are too costly or impossible to write. The typical features of a failed vertical market are (1) a small number of buyers and sellers; (2) high asset specificity, durability, and intensity; and (3) frequent transactions.

A second reason to consider vertical integration is to defend against supplier power. Firms may consider integrating when another company in an adjacent stage of the supply chain has more power. Suppliers with more market power can extract abnormally high prices from their customers. It is important to note that entry via acquisitions will not create value for the acquirer if it has to hand over the capitalized value of the economic surplus in the form of an inflated acquisition price. Often, the existing players in the less powerful stages of an industry chain pay too much for businesses in the powerful stages.4

The final reason a firm may consider a backward integration is to create or exploit market power. Markets where there is a high degree of vertical integration typically have higher barriers of entry. New entrants to the market will likely have to enter all stages of the supply chain in order to compete. This increases capital costs and the minimum efficient scale of operations, thus raising barriers to entry. However, using vertical integration to build entry barriers is often, an expensive ploy. Furthermore, success is not guaranteed, as inventive entrants ultimately find chinks in the armor if the economic surplus is large enough.5

Quasi-Integration Strategies

Stuckey and White argue managers sometimes over-integrate because they fail to consider the rich array of quasi-integration strategies available. Long-term contracts, joint ventures, strategic alliances, technology licenses, asset ownership, and franchising tend to involve lower capital costs and greater flexibility than vertical integration.6 Apple has historically used many of these strategies. The recently signed long-term contract with sapphire glass maker GT Advanced is a good example. The terms of the contract require GT to maintain certain capacity levels and exclusivity. In addition, GT announced the agreement would cause margins for their sapphire glass to drop considerably compared to historical levels. The announced agreement shows the power of quasi-integration strategies. Apple now has significant control over sapphire glass supply at a lower than historical cost. In addition, the exclusivity stipulations may shutout key rivals. The benefits came at a fraction of the price of a complete buyout and allow flexibility to move to better technology should it come along.

Acquiring Micron Technology Inc.

Micron Technology Inc. produces dynamic random access memory DRAM and NAND flash memory products for the consumer electronics industry. Both DRAM and NAND are used in Apple products including the iPhone, iPad, and Mac product lines. The charts below show the DRAM and NAND markets are dominated by only a few firms. Additionally, the barriers to entry into these markets are high, as a new NAND or DRAM facility would cost billions to build.

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The oligopolistic structure and high barriers to entry signal the benefits of vertical integration may outweigh the costs. However, a review of Micron's financial statements for the past five years shows the company has barely produced an operating profit and has been unable to defend against price decreases (see below). It probably doesn't make sense for Apple to pour $30 billion entering an industry where the product selling price is at or near cost. Unless the market structure changes significantly, the benefits of a vertical merger into the DRAM/NAND market would likely not outweigh the costs.

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Acquiring Sharp Corporation

Sharp Corporation manufactures and sells consumer/information products and electronic components. Apple's supplier list and tear down analyses indicate Sharp supplies displays for several Apple products including the iPhone and iPad. The supplier list also indicates Apple uses many other display vendors including Japan Display, LG Display (LGL), Samsung, Sharp, Sony (SNE), Innolux Corporation, and AU Optronics (AUO). A cursory review of Sharp and LG Display's financials show that the display market is ultra-competitive with both firms having low or negative operating margins (see below). An ultra-competitive market like this is typically a poor choice for vertical integration because Apple is able to source their supply at or near cost with little or no capital investment.

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Acquiring GlobalFoundries

The foundry space has many players, but is dominated by industry giant Taiwan Semiconductor with almost a 50% market share (see below). Additionally there are only a few players (Intel (INTC), GlobalFoundries, TSM, and UMC) that could potentially take on Apple's full demand of cutting edge chips. Despite limited players owning technologically advanced foundries, a review of the financials show the industry is also very competitive. Both GlobalFoundries and UMC operate at losses or near breakeven with Taiwan Semiconductor the only one with respectable operating margins among the pure-plays.

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Should Apple Backwardly Integrate?

The first two reasons Stuckey and White provide to vertically integrate were vertical market failure and defending against supplier power. Based on the analysis above, it's unlikely the NAND/DRAM, display, or foundry market runs the risk of vertical market failure. There are sufficient firms in each industry to mitigate coordination issues between buyers and sellers. Additionally, the financials of firms in these industries indicate they have very little power to extract high prices from Apple.

The final reason to backwardly integrate is to create or exploit market power. The argument Ashraf made was Samsung has more market power than Apple due to their vertical integration into NAND/DRAM, display, and foundry. However, Apple is already vertically integrated in areas where Samsung is not, which gives Apple competitive advantages that are hard to match.

One significant advantage Apple has over Samsung is it owns its own ecosystem. Samsung doesn't pay a dime for Android; however, they split revenues with Google for ads, apps, and music while Apple gets the whole pie.

Additionally, Apple customizes its own chips. In 2009 Apple began a hiring spree to develop a team to design its own ARM based chips. Last year, the Apple A6 chip was the first to have its cores designed from the ground up by Apple engineers. The move allowed Apple to customize the chip's micro-architecture which led to a faster processor than their competitors. Moving the design function in house also freed Apple to move their chip production to pure-play foundries. These foundries focus only on manufacturing and typically charge lower prices. Currently all of Apple's chips are manufactured through Samsung foundries. However, recent rumors suggest Apple is moving some capacity away from Samsung to pure-play foundries like Taiwan Semiconductor and GlobalFoundries.

Another significant advantage for Apple is they are forwardly integrated with their retail stores. Selling products directly to the consumers though owned stores allows Apple to capture the entire sales price of the product, whereas Samsung has to split a portion with a third party retail outlet.

Apple's consumers are also more brand loyal than Samsung's. A 2012 study by UBS revealed that nine out of every ten iPhone owners indicated they will never buy another brand of smartphone. A recent study by Yankee Group showed nine percent of Apple owners plan to switch to another platform with their next phone purchase, while 24 percent of Android owners plan to defect from the Android platform, 18 percent of which were planning on switching to Apple. Consumer Intelligence Research Partners (CIRP) conducted a survey from June 2012 to June 2013 showing Apple stole around 20% of Android customers during the period, while Samsung only stole 7% of Apple's (see below). Companies with more brand loyalty enjoy higher margins, cost effective marketing, and robust defense against price competition.

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Conclusion

There are certainly reasons to question how Apple runs aspects of their business. Decisions like hoarding $150 billion in cash and spending $5 billion on spaceship campuses frustrate many shareholders. However, supply chain management should be pretty far down on the list of complaints. CEO Tim Cook was brought to Apple in 1998 because of his operational genius. He reduced the number of key suppliers and forced them into competition with each other which lowered prices. Within two years he had cut the manufacturing life cycle in half and reduced inventory on hand from 2 months to 6 days. Cook is wise enough to only vertically integrate when it is cost effective. When it isn't, he will pursue quasi-integration strategies where Apple gets most of the benefits of vertical integration while limiting the costs.

Suggesting Apple throw billions of dollars at vertical integration simply because a competitor is integrated does not adequately weigh the costs and risks of the strategy. Have some faith in Tim Cook and his supply chain management.

1 Rosita P. Chang, CFA and Keith M. Moore, CFA, Corporate Finance: Mergers and Acquisitions (CFA Institute, 2012), 222.

2 John Stuckey and David White, "When and When Not to Vertically Integrate," McKinsey Quarterly (August 1993).

3 Stuckey and White, 1993.

4 Stuckey and White, 1993.

5 Stuckey and White, 1993.

6 Stuckey and White, 1993.

Source: On Apple And Vertical Integration