Corporate Finance
Feb 21, 2023
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This guide explains what vertical integration is. Vertical integration is important for both entrepreneurs and M&A professionals to understand. Here are some key points:
To understand how vertical integration works, you need to understand how supply chains work. The term supply chain refers to the process of creating the product all the way through to selling it to the customer.
The supply chain required to produce an iPhone is a good example.
First the raw materials required to make the glass, case, and microchip, etc. are sourced. Next the glass, microchips, and case are manufactured, then they are sent to a separate facility where they are assembled into the iPhone. Then they are shipped to apples retail stores and warehouses. Then they are sold in retail stores and online to customers. The customers are the end users.
Vertical integration occurs when a company has ownership of at least two of the processes required to source, make, distribute, or sell the product. So, a retail company that also owns a shipping distributor or a manufacturing plant can be said to be vertically integrated. A retail store chain with no other operations can’t.
Vertical integration is typically achieved through mergers & acquisitions—meaning that a company buys another company somewhere along the supply chain.
Vertical integration can also be achieved through expanding your own operations organically over time. Meaning that a retailer would build and start its own manufacturing plant instead of buying one, as an example.
This guide is going to look at vertical integration resulting from mergers or acquisitions, because it is the more common way vertical integration is achieved. This is because it’s often faster, and usually more cost effective to buy existing operations than to build out and learn the process yourself.
In the M&A process a company buying another company on its supply chain would be classified as a strategic buyer and would have the primary goal of achieving financial synergy. Financial synergies are cost savings or revenue enhancements that come about as a result of doing the deal. To learn more about financial synergy, read our guide here.
Some key advantages (cost savings) to vertical integration are that it lowers variable production costs, improves operational efficiency, and often results in shorter turnaround times. Economies of scale can come into play as well if the end result is large enough.
Some other notable benefits that can arise from vertical integration include improved quality control now that the company can oversee more of the process, shorter turnaround times, and simpler logistics.
There is also a benefit to becoming less reliant on external suppliers or distributors who could increase costs down the road.
From a revenue enhancements perspective, vertical integration can also give a business the ability to produce more volume, potentially giving the business the ability keep up with growing demand. Additionally, profit margins usually rise when middlemen are removed from the process. Depending on whether the company is moving forward or backward along its supply chain, there may also be opportunities to push price points as a result of vertical integration deals.
Generally, vertical integration is thought of as a positive thing. If done correctly the benefits are hard to ignore and there's a centuries-old track record of vertical integration deals working out favorably.
However, there are potential drawbacks to vertical integration as well.
The most obvious drawback to vertical integration is that it can require a large cash outlay. That’s cash that can’t be used for other things. Additionally, vertical integration adds to the complexity of operations. Meaning that now the company has a more complicated business to manage than it did before the deal.
These deals can also take a long time to complete. Even though this time is probably less than it takes to build out these operations without a merger or an acquisition—it’s still a substantial amount of time that that company has to take away from focusing on core operations.
On a more technical note, in M&A a primary reason why deals fail in the end is that the acquirer pays a premium for a company on the assumption that it will recoup this investment in cost savings and revenue enhancements over the long-term—and it doesn’t.
If they were to overpay there is an effect of destroying value.
For a publicly traded company, how this affects the acquiring company depends on whether the deal was structured as an asset purchase or as a stock purchase. In an asset purchase, the acquirer buys the business’ assets one by one, until it owns everything it wanted to acquire.
When they overpay for a business, the difference is an intangible asset (called goodwill) that goes on the balance sheet. This difference (the amount they overpay) can be amortized in the case of an asset purchase, and this offsets the overpayment with tax savings down the road. Under US GAAP, goodwill is tested annually for impairment for public companies. If value is destroyed, there are goodwill impairment charges which will have the effect of destroying some of the value this deal hoped to create. For private companies, they can amortize goodwill regardless of the deal structure (asset vs stock purchase), and they are exempt from the annual impairment testing that public companies are subject to here.
However, regardless of accounting, overpaying for something that fails to live up to expectations is a bad thing in business.
Part of the rationale for buying a business resulting in vertical integration is that inorganic growth can add to a company’s value relatively quickly. Some or all of that extra value could be destroyed if the company overpays for an acquisition and in the end can’t create a big enough upside with its vertical integration to justify it. You can learn more about organic vs inorganic growth here.
In practice vertical integration happens in two ways, either a company moves backward, towards the raw materials, or they move forward, towards the end customers. This is illustrated below:
If a final assembly manufacturer moves forward one step in the process, they would be acquiring a shipping/distribution company. This may be more profitable for them as they could offer manufacturing and delivery of the assembled products, conceivably at a higher profit margin.
If that final assembly manufacturer were to go one step higher then they would be buying a retail store chain or an ecommerce website. This would give them control of how their products are marketed and how the final product is priced to the end customer.
Owning the supply chain process as the combined final assembly manufacturer, shipping distributor, and end retailer would give this company the ability to charge retail prices to consumers—but have substantially better profit margins than a competitor retail business would.
That same final assembly manufacturer could also move backward in its vertical integration, buying a raw materials sourcing company or a component parts manufacturer. These would allow them to sell their product to end retail companies at much higher profit margins because they cut out the middlemen between the raw materials and the final assembled product.
