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New York Times columnist Thomas Friedman made a mint telling us that The World Is Flat. In his 2005 bestseller, he made the point that globalization, information technology, and logistical strategies have combined to level the playing field in the world's economy, letting participants previously shut out of the system to dominate certain niches. Smart companies, he suggests, don't do everything themselves because it's so easy to spread functions out around the globe.

Dell's (Nasdaq: DELL  ) use of "just-in-time" inventory management is a prime example: By sourcing components from around the world to meet demand hour by hour, the company minimizes its own inventory carrying costs. It keeps no more parts on hand than it needs to meet current orders, a feat made possible by Dell's locating its factories near its suppliers and using sophisticated supply chain management software to coordinate orders and fulfillment.

That's worked pretty well for Dell, even if the company looks a little less invincible these days than it once did. But the flat-world mania it represents has blinded many investors and analysts -- and even some companies -- to the beauties of vertical integration.

The problems with the flat world
Competitive advantage comes in a lot of flavors -- patents, trade secrets, and know-how; better management; superior strategies; or even a simple head start. Over time, most of these advantages dwindle. Patents expire, and competitors learn from your mistakes and successes. But one advantage that can be hard for newcomers to duplicate is scale. It's why Wal-Mart is still on top, despite having its business methods dissected daily by B-school students. It's why Dell is still one of the leaders in PC sales. Even in a smaller industry, where one might not think in terms of "critical mass," scale can create long-term winners and losers.

Optical components are an example of an industry that got severely flattened -- in more ways than one -- in the wake of the telecom bust earlier this decade. Much of the market for the optical amplifiers, switches, routers, and multiplexers that control the flow of long-haul Internet data used to rest in the hands of large, vertically integrated companies. Now tiny Avanex owns the former optical components businesses of Corning (NYSE: GLW  ) and Alcatel-Lucent (NYSE: ALU  ) , while Nortel (NYSE: NT  ) sold off its components business to micro-cap Bookham. Most other companies in the space are small with limited resources and focused on the same kinds of products.

As a result, systems integrators looking to put together innovative networking products face severe limitations. Like Dell, they are limited to assembling what are essentially commodity components.

Getting vertical
Venture capitalists looking at this flat world realized that it stifled innovation. Few companies had the ability or means to engineer innovative optical components with electronics from the ground up to create something truly new. So venture capitalists were willing, even in the wake of the telecom bust, to fund Infinera (Nasdaq: INFN  ) to the tune of about $315 million over several years.

The ultimate result was a line of unique networking products that can cheaply and easily move data back and forth between the optical and the digital realm in one integrated circuit -- putting the company years ahead of its competition. Those other small, dispersed companies don't have the tools to make something so out of the ordinary. And the larger companies that might have more means to design from the ground up have lost the internal integration needed to do so. They're set up for a flat world, while Infinera rejected the commodity approach and reinvented components to its own specs. 

IPG Photonics (Nasdaq: IPGP  ) did a similar thing in the laser industry, carving out commanding dominance in fiber lasers, in part, by manufacturing all the key components for its products. Vertical integration not only allows IPG to enhance innovation by controlling all the specs of its products, but also to lower costs and keep its lead over competitors. The company even sells its hand-rolled laser diodes to other OEMs, who take a more Dell-like approach to creating products and thus pose a limited competitive threat. IPG has a market cap of only about $715 million, but in the relatively small commercial laser industry, its invested capital in fiber lasers is something competitors will find hard to duplicate.

There's a cost to this, of course
Blinkered analysts focused just on balance sheet metrics will note that IPG, for instance, has higher inventory costs and slower inventory turns than some of its competitors. That's part and parcel to the company's strategy: Since inventory turns measure the time it takes from getting materials in to getting finished products out the door, a company like Dell that assembles ready-made parts is going to have much different numbers that a company getting in raw material and building its own components.

Yet Wall Street puts pressure on companies to keep numbers looking the way they like them -- and that can have real consequences. Online jeweler Blue Nile (Nasdaq: NILE  ) , for instance, tries to keep its inventory costs low with just-in-time procurement of diamonds and precious metals. That prevents the company from tying up a lot of capital in what are, after all, some very expensive raw materials. It doesn't save them much in carrying costs, however, because diamonds don't exactly require huge warehouses or large trucks to move them around. And it opens the company to the volatility of commodities prices. Management discovered that earlier this year when the spot price for diamonds spiked. With little inventory to fall back on, management had to eat the higher costs.

Flat may be trendy, but there a lot of advantages to being vertical -- and recognizing them can be critical for investors who want to look past the flavor of the week and find businesses with lasting advantages.

This week, David Gardner and a team from Motley Fool Rule Breakers are on an "Innovation Tour" around Silicon Valley. We'll tour companies, meet with management teams, and meet with venture capitalists to survey the businesses that have lasting competitive advantages. You can get all our dispatches and thoughts from the trip -- free of charge -- just click here and enter your email address.

Karl Thiel owns shares of Infinera, but no other companies mentioned. Blue Nile, Infinera, and IPG are Motley Fool Rule Breakers recommendations. Wal-Mart and Dell are Inside Value selections. The Motley Fool owns shares of Infinera and IPG and has a disclosure policy.

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  • Report this Comment On January 04, 2009, at 4:22 PM, investingNideas wrote:

    You forgot to add Enablence as yet another example of a company vertical integrating all the parts to make a GPON network cheap. Enablence has purchased Pannaway and Wave7 Optics (system vendors) and DuPont, ANDevices, and Albis for the components, switch and Osaki Electric Group has also been building products with Enablence which may lead to another purchase of that product line.

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