Sleeping With the Enemy Part II

In an earlier post, I noted Target’s costly decision to end its on-line outsourcing arrangement with Amazon’s cloud service and take all its work in-house. The short-term costs were considerable, both in direct outlays and in performance degradation, and the long-term benefits were hard to pin down. Vague paranoia rather than careful analysis seemed to have driven the decision. I pointed out that firms often seemed unwilling to “sleep with the enemy,” i.e. purchase critical inputs from a direct rival, but the case for such reluctance was weak.

A few months ago, an apparent counterexample popped up. Swatch, the Swiss wristwatch giant, decided unilaterally to cease supplying mechanical watch assemblies to a host of competing domestic brands that are completely dependent on Swatch for these key components. These competitors (including Constant, LVMH, and Chanel) sued, fruitlessly, to force Swatch to continue to sell to them. The Swiss Federal Administrative Court  backed up a deal Swatch cut with the  Swiss competition authorities that allows Swatch to begin reducing its shipments to rivals. The competition authority will report later this year on how much grace time Swatch’s customers must be given to find new sources of supply, and these customers may appeal to the highest Swiss court. For now, Swatch’s customers are scrambling for alternative sources of supply in order to stay in business. The stakes are especially high because overall business is booming, with lots of demand in Asia.

(Before getting to the strategy questions, I have to get one thing off my chest: Why would anybody choose to buy an expensive mechanical watch in the 21st century? Higher priced, less reliable, less accurate, less durable, requiring more attention to keep running, and with identical visual aesthetics–mechanical watches seem completely inferior to quartz movements [or even the old Bulova tuning fork technology]. I imagine mechanical watch users wearing monocles and writing with quill pens as they groom their powdered wigs.)

Having completed my off-topic rant, does the Swatch episode provide an object lesson justifying refusal to sleep with the enemy? Would the bevy of small Swiss mechanical watch producers have been better off all along to have been vertically integrated into designing and manufacturing the mechanisms? Was Swatch’s mechanism business really analogous to Amazon’s cloud services? A few points, in no particular order, that might help us distinguish cases where sleeping with the enemy might be dangerous.

1. Adding incremental production capacity for Swiss movements is more expensive and difficult than adding server capacity in a cloud computing system. Nick Hayek, the head of Swatch has stated publicly that he wants to allocate more of the firm’s production capacity to its own brands such as Omega, Longines, and Breguet. He has professed weariness with Swatch being treated as a mechanical parts “supermarket” by its rivals/customers, “forced to deliver to everyone whatever they want.” (Apparently, Swiss competition law, until the settlement, treated Swatch as a monopoly supplier because of its 70% share of all Swiss movements and constrained management’s freedom to tell customers to buzz off.) The situation is very different with Amazon’s cloud services; the company acts as if it believes that there are strong increasing returns to serving more of the market and it aggressively solicits outsourcing contracts.

Lesson: Sleeping with the enemy is riskier when the input’s production capacity is scarce and costly to expand.

2. Swatch’s “monopoly” position in manufacturing Swiss movements is a legacy of its rescue and consolidation of a collapsing industry in the 1980s. In past years, Swatch has repeatedly urged its rival/customers to invest in their own production capacity, to little avail. By contrast, Amazon has nothing like a monopoly in cloud services and Jeff Bezos has gone out of his way in interviews to discourage companies from trying to build their own infrastructure, likening it to a firm having its own power plant.

Lesson: Sleeping with the enemy is riskier when the supplier is not committed to the outsourcing business.

3. Swiss watch manufacturers are limited in their ability to find alternative sources of supply by their need to claim that their watches contain “Swiss movements.” This designation is only legal for products actually produced in Switzerland, preventing the buildup of a lower-cost supply source in places like Poland or Taiwan. Thus, the original decision to sleep with the enemy was probably pretty rational–the present value of free-riding on Swatch’s capital investments likely exceeded the disruption costs the firms now face.

Lesson: Even when sleeping with the enemy is risky, it may still be worthwhile to play out the string as long as possible.

Hmmm. Do you think the Target/Amazon and Swatch/Constant, etc. situations would make good instructional cases?

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