Vertically Integrating Space

Why Vertical Integration Worked for SpaceX

The Acquired podcast episode on SpaceX has a detailed discussion about the merits of vertically integration.

In so many industries you see the disruption happen when you go from the vertical to the horizontal.

You saw this in PC industry when you had mainframes and few units shipped. As volume is growing, you get a lot more units shipped and price goes down.

You can start outsourcing commodity parts. It makes sense to horizontally integrate and specifically pick parts of the stack where you'll have the most power. And generate margins from there [while the other parts of the stack see deteriorating margins and returns].

David and Ben then notice that this isn’t true with the rocket industry.

For rocket launches you had an extremely small number of n and it was horizontally integrated players that were competing for contracts.

SpaceX came in and said there are anti-economies of scale and that this should be vertically integrated.

They go back and forth for why this happened, and whether the inverse is true (for example, Apple and the iPhone).

I think the explanation is pretty simple actually. The nature of Cost Plus Contracts make it so that every company is incentivized to let costs increase so they generate larger revenue, albeit on a fixed gross margin/profit margin basis.

In the case of aerospace, because the industry was horizontally integrated and the Primes were acting as integrators, this created an incentive structure where every component layer had a fixed margin percentage stacked on top of itself.

Everyone is incentivized to make their product as expensive as possible, and pass that cost on to the buyer. The next buyer would pass that cost along to the next buyer (all the way up to the US Govt).

When this happens vertical integration becomes attractive for multiple reasons:

1. The profit margins the component providers layer in get eliminated, revealing the “true price” of the component.

2. Each layer of integration experiences a sustainable cost savings.

3. You can stack multiple layers (and cost savings) together to achieve a seemingly-exponential cost reduction in the end product (in this case rockets).

4. The additional control and margin improvement provide flexibility, which lets you upgrade specific parts faster than the rest of the market will.

5. Faster upgrades further compound your cost advantage by providing better performance on a relative cost basis (and guarantees your long term supply).

All of this creates a strong flywheel where you’re incentivized to ruthlessly reduce costs, reevaluate new technologies, and embrace a higher iteration cadence.

The legacy aerospace industry looked like a giant, fully extended accordion. SpaceX compressed the accordion, bringing total costs down while increasing overall margins.

They introduced an orthogonal business model that the Primes would never choose to replicate. And as a result they now look fundamentally different than every other company in the category.

A compressed accordion