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February 10, 2005

AT&T: Lesson From the Crypt #3: Vertical Integration Doesn’t Work Anymore

Vertical integration is probably the most important reason why AT&T failed.  SBC’s planned acquisition of AT&T is a mistake, I believe, because it is a step toward vertical reintegration at a time when horizontal, not vertical, excellence is necessary for success and even survival.

Once upon a time, the computer industry was a model of vertical integration.  IBM manufactured chips and computers, wrote operating system and application software, taught courses and provided consulting, and even sold made and sold punch cards and time clocks.  Each of the seven dwarves, the companies that tried to compete with IBM in those days, was vertically integrated as well.

The came the microcomputer.  Society changed as computing power migrated from the splendid isolation that mainframes lived in to the desktops of end-users.  The business of computing changed as well.  It became horizontal. There are a proliferation of retail outlets on and offline; computers are manufactured all over the world from components whose sources are equally varied.  Intel dominates the chip layer; Microsoft the operating system and application layers.  IBM almost died as a result of this change.  Just in time, it adapted and is still alive and ticking although not its former dominant self.

AT&T at its height was a marvel of vertical integration.  It made phones, made and strung wire, owned the subs that tend undersea cable, launched satellites, made switching equipment; and, of course, provided local and long distance service.  It had a fleet of cars larger than Hertz.  It employed a million people.  It was so large that it insourced almost everything.  Most phone companies around the world were similarly vertically integrated.

It may have been that in yesterday’s world of poor communication, vertical integration was an advantage.  If you have a monopoly in  any single layer and can sustain that monopoly, then you can have even greater profit by moving into dependent layers above and below and using your monopoly position to assure dominance and high profits in those layers as well.  The carriers of the world were government-sanctioned and government-regulated monopolies if not simply a branch of the government.  They survived and prospered in their vertically-integrated form until the dawn of competition.

Vertically integrated companies can’t compete!  The oxymoron of “internal customers” is poison to a competitive culture.  That is the lesson of the computer industry and it is a lesson the telecommunications industry apparently has not learned yet.

At its launch AT&T WorldNet Service was able to get a competitive advantage as an ISP by being able to use 200 existing AT&T owned and operated dial PoPs (Points of Presence) which had been built for another service.  These provided the local numbers essential to making Internet access affordable and offering a fixed monthly rate.  Score one point for vertical integration.

Meanwhile UUNet, a very focused horizontal company, was busy building local PoPs; but they started out far behind AT&T.  UUNet was not an ISP itself.  Instead, it rented its PoPs out to retail ISPs by the minute to enable them to provide local access.  Early customers included Microsoft’s fledgling MSN as well as small local ISPs.  UUNet had many customers for its PoPs.  Only AT&T services, mainly WorldNet, could use AT&T PoPs.

The UUnet PoPs were new and state of the art;  AT&T’s were not.  The UUNet PoPs were not guarded by a union work force.  AT&T’s were.  So AT&T PoPs had a much higher cost per minute of use than UUNet PoPs.  As the captive “customer” for AT&T PoPs, we at WorldNet weren’t happy with the price we paid even though we appreciated the reliability.  But money to upgrade the PoPs and to build new ones would have to come from the budget for the Network Division (a different layer!), not from WorldNet. The Network Division had other priorities and potential business from WorldNet alone didn’t justify a very aggressive buildout.

UUNet had real external customers and built to meet their needs.  AT&T had only itself for a “customer” and so didn’t have enough incentive or enough business to build the world’s best network of PoPs.  Soon UUNet had more PoPs than AT&T.  That meant than a tiny startup ISP like EarthLink, on the day they went into business, had both more PoPs available and a lower cost per minute than AT&T WorldNet.  EarthLink inherited the breadth and economies of scale of its supplier UUNet.

Eventually WorldNet wanted to buy from UUNet to lower its costs and increase its geographic coverage.  But these purchasing decisions are made by corporate politics and not by the marketplace in vertically integrated companies – it’s called “serving the greater good” or “being a team player”.  WorldNet was not allowed to take its traffic off AT&T’s network and out of its PoPs.  WorldNet could not use its own size to achieve a good deal with UUNet.  WorldNet was now at a competitive disadvantage to EarthLink.  Score two points against vertical integration. Eventually AOL sold its own PoPs and used UUNet, among others, to provide access.  AOL did not let itself be a prisoner of vertical integration.

Meanwhile, AT&T was not selling access to its PoPs to other ISPs because that would have been bad for WorldNet.  AT&T, in theory, could have built a network much bigger, better, and cheaper than the one UUNet cobbled together.  In fact, UUNet did not hesitate to lease network connectivity from AT&T where it made sense to them to do so.  So, not only did AT&T lose the opportunity to be a great retail ISP, it also lost the opportunity to be a dominant supplier of local access.  Score two more points against vertical integration.

A horizontal company has a high surface to volume ratio.  It sells all of its outputs in a competitive market.  It is free to buy all its inputs in a competitive market.  Its managers are not isolated from the markets they compete in.  A vertical company spends most of its time and energy dealing with itself rather than the external market.  Meetings are dominated by esoterica like transfer pricing between divisions because this is what determines internal success.  The real marketplace is distant from most of the managers trapped inside the vertical structure.  Buy vs. build and capital allocation decisions inside a vertical company are made by office politics in a vain attempt to optimize across the whole vertical organization.  Horizontal competitors optimize only for the layer they are competing in and so end up being superior to the vertically integrated company layer by layer.

SBC clearly believes it can make vertical integration work.  I don’t think so but it’ll be interesting to watch and learn.

Lesson from the Crypt #1 is don’t manage for quarterly results.

Lesson from the Crypt #2 is you can’t innovate flawlessly.

Lesson from the Crypt #4 is don’t sent your losers to heaven.

Lesson from the Crypt #5 is navel gazing is a bad culture.

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