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.

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Sleeping with the enemy

Target used to outsource its e-commerce service provision to Amazon. Recently they decided to bring these operations in-house and have had some teething problems. After two embarrassing crashes, they’ve patched the site up for the holiday season and the former head of the operation has abruptly left the company. (One problem Target faced in quickly trying to build their site is a scarcity of programming talent–even hot Silicon Valley companies are having trouble recruiting skilled Web architects and coders.)

A simple question: Why is Target doing this? The question is not simply a classic make-or-buy decision but a decision about whether to “sleep with the enemy” by purchasing essential upstream inputs or services from a downstream rival. This issue comes up quite frequently in company scope discussions. One Harvard Business School case where it explicitly arises is PepsiCo’s Restaurants. Burger King, which had long poured Pepsi from its fountains (in contrast to the “all-American” combination of McDonalds and Coke), switched to Coke when Pepsi bought Taco Bell and KFC. The case claims that Coke salesfolk successfully argued that BK shouldn’t buy soda from its competitor in fast food.

There’s an instinctive tribal emotion that might motivate such behavior, but is there any rational reason to avoid “sleeping with the enemy” in this fashion? An oligopoly analysis actually favors such promiscuity, since being an upstream customer of one’s downstream rival actually reduces the rival’s incentive to steal customers from you (since they now have to net out the lost upstream sales). This effect reduces the rival’s willingness to make sunk promotional expenditures, for example, to capture market share from you–a point of market share grabbed from you now makes a smaller impact on the rival’s bottom line.

The obvious fear is of sabotage by one’s “enemy supplier.” (The rival would be raising your cost or reducing your value to gain a stronger competitive position.) This is the most common response given by outside analysts of Target: As e-commerce becomes more important, a company cannot allow its destiny to be controlled by a rival like Amazon. Given some past problems between Amazon and Toys R Us, this isn’t completely crazy, but as one analyst pointed out, Amazon has every incentive now to maintain a reputation as a reliable provider of cloud services given its giant investment in this fast-growing area.

 Here you have to look at the reputational impact on your rival’s upstream business if it’s caught doing this, as well as potential legal remedies you might have available (and might be able to negotiate contractually). Unless the supplier has subtle ways of screwing you that wouldn’t be easy for you to detect or to prove to others, this risk seems reasonably easy to control. (If the rival supplier is not a profit maximizer, e.g. a state-owned enterprise, the risks go up.)

Most of the other fears that firms could rationally entertain are the traditional ones for outsourcing, even from suppliers who are not also downstream rivals. For example, maybe Target anticipates the need for asset-specific investments between its e-commerce activities and its brick-and-mortar businesses and believes it faces either ex ante investment incentive problems a la Grossman and Hart or ex post haggling problems a la Williamson. I’m not sure just what these would entail that couldn’t be handled effectively with long-term relational contracts, but in any case Amazon’s status as a downstream rival has no bearing on them.

So it’s hard to come up with a plausible argument against sleeping with the enemy. But managers and analysts frequently express discomfort with it. Am I missing something?