Vertical Integration – Merger Strategy How Vertical Integration Works (Step-by-Step) Vertical integration consists of a company taking control over at least two steps in a given value chain, such as the production, distribution, or selling of the finished good or service, as opposed to outsourcing certain tasks.
The vertical integration of a supply chain implies that each step of the process is owned and closely controlled by a combined entity.
If a company publicly announces its plans to control and own aspects of its supply chain rather than relying on external suppliers as it did in the past, the shift is called “vertical integration”.
Furthermore, the merged company possesses a greater proportion of the total market share , which directly causes its buyer power to increase and gives it more negotiating leverage over its suppliers and distributors.
The end goal for pursuing vertical integration is to streamline the operational process from start to finish, i.e. having more ownership over all of the various stages in a production process.
Companies often opt to outsource or rely on external 3rd parties in an effort to reduce spending, yet sub-par production and quality issues can cause real damage to the branding of the company and diminish the trust of their customer base.
Therefore, vertical integration consists of a company possessing ownership over most, if not all, stages of the production cycle, including the suppliers and distributors.
Pros/Cons of Vertical Integration Normally, the supply chain process starts with purchasing raw materials from suppliers – followed by a wide range of potential steps depending on the context – until the final product reaches the customer.
The strategy of vertical integration implies the company controls multiple stages in its supply chain, thereby reducing or even eliminating the need for reliance on any third parties.
Vertical integration can result in the production process becoming more efficient with reduced costs (and higher profit margins ).
The drawback, however, is that there is a great number of initial costs that are required to build the infrastructure and purchase the necessary equipment. Until the company recoups the initial cost, the integration would remain unprofitable.
Ownership of the supply chain from start to finish might initially sound appealing, but more control over the process does not necessarily result in higher quality.
While factors such as communication may be improved, the management team must have a thorough plan in order to be capable of managing every step of the production process.
Having an inept management team responsible for overseeing the complex supply chain can be very risky.
Vertical Integration Example: Electronics Supplier Acquisition Suppose an electronics company decided to purchase a supplier that they have worked closely alongside in the past, and those suppliers’ parts (and components) are crucial inputs to the device.
If the electronics company decides to purchase the supplier to reduce manufacturing costs and streamline its operations, the acquisition would be an example of vertical integration.
Additionally, another example of vertical integration includes purchasing trucks and fleets of vehicles to transport the parts, i.e. the company is now in control of the entire distribution process.
Types of Vertical Integration: Forward vs. Backward Integration There are two types of vertical integration:
Forward Integration → When an acquirer moves downstream; i.e. the company’s acquisition target moves them closer to the end customer, e.g. distributor or technical support.Backward Integration → When an acquirer moves upstream, the company is purchasing suppliers or product manufacturers (that are further away from the end customer).
A company undergoing backward integration is shifting its ownership and control of the process to an earlier point in the supply chain, whereas a company pursuing forward integration is moving forward to own and control the production stages that interact more closely with the end customers, such as the distribution process.
Vertical Integration vs. Horizontal Integration Horizontal integration refers to a merger where competitors are combining their operations (and asset base) to benefit from economies of scale , increased buyer power over suppliers and vendors, and expanding their reach into new geographical locations (and end markets).
The differentiating factor between horizontal integration and vertical integration is that horizontal integration is the merger of close competitors operating in the same market.
On the other hand, vertical integration is between companies operating at different stages in the value chain and with distinct responsibilities in the production cycle.
In contrast to horizontal integration, vertical integration consists of a merger involving companies functioning at various levels of the value chain, such as either upstream or downstream activities.
Each company engaged in vertical integration has its own unique role at a specific stage of the production process.
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In acquisitions, buyers usually pay the seller with cold, hard cash.
However, the buyer can also offer the seller acquirer stock as a form of consideration. According to Thomson Reuters, 33.3% of deals in the second half of 2016 used acquirer stock as a component of the consideration.
For example, when Microsoft and Salesforce were offering competing bids to acquire LinkedIn in 2016, both contemplated funding a portion of the deal with stock (“paper”). LinkedIn ultimately negotiated an all-cash deal with Microsoft in June 2016.
Horizontal Integration occurs from mergers among companies directly competing in the same or closely adjacent markets.
The companies involved in a horizontal merger are normally close competitors that provide goods or services at the same level in the overall value chain.
Horizontal Integration – Merger Strategy
Horizontal integration is a type of merger where competitors operating in the same market combine their operations to benefit from economies of scale .
If two companies that offer virtually identical or similar goods or services decide to undergo a merger, the transaction is considered to be horizontal integration.
The horizontal integration strategy – in which two companies operate at the same level of the value chain and decide to merge – enables companies to increase in size and scope.
Together, the combined entity’s reach is far broader in terms of expanding into new markets and diversifying a consolidated portfolio of offerings.
The result is the creation of economies of scale, wherein the post-merger company obtains cost savings from the expanded scale.
Economies of Scale → The cost per unit of output declines with increased scale up to a certain pointGreater Production Output → The efficiencies related to production such as streamlined processes enable the company to produce a greater number of units at their manufacturing facilities.Buyer Power → The combined company can purchase raw materials in bulk for steep discounts and negotiate other favorable terms.Pricing Power → Given the limited number of competitors in the marketplace, the combined company can make the discretionary decision to increase prices (and the few other companies in the market then normally follow suit).Cost Synergies → The entity benefits from cost synergies , namely shutting down redundant facilities and duplicate job functions deemed to no longer be necessary.
Regulatory Risks of Horizontal Integration
If integrated properly, the profit margins of the merged company are most likely to increase, although the revenue synergies can take substantially more time to materialize (or may never actually occur).
The major risk associated with horizontal integration is the reduction in competition within the market in question, which is where scrutiny from regulatory bodies comes into play.
The benefits derived from the companies participating in the merger come at the expense of consumers and suppliers or vendors.
Consumers : Consumers now have fewer options because of the merger while suppliers and vendors have lost more of their bargaining power.Suppliers and Vendors : The merged company possesses a greater proportion of the total market share , which directly causes its buyer power to increase and gives it more negotiating leverage over its suppliers, vendors, and distributors.
Of course, the risk of the merger failing to deliver the expected synergies is inevitable.
Horizontal mergers are therefore not without risk.
If the integration is done poorly – for example, suppose the differing cultures of the companies cause other issues – the result from the merger could be value-destruction, rather than value-creation.
Horizontal Integration and Oligopoly
Often, the economies of scale and cross-selling to each other’s customer bases as a result of horizontal integration can be the catalyst preceding the creation of an oligopoly, in which a limited number of influential companies hold most of the market share in an industry.
Sprint and T-Mobile Merger – Anti-Trust Suit and Controversy
Following the completion of a horizontal merger, competition in the market declines, which is typically brought to the attention of the appropriate regulatory bodies immediately. i.e. anti-trust concerns are the primary drawback to horizontal integration.
For example, the Sprint and T-Mobile merger is a relatively recent horizontal merger that was under heavy regulatory scrutiny.
The controversial merger was approved by the U.S. Justice Department and Federal Communications Commission (FCC) in 2020 after a multi-year anti-trust suit after the carriers agreed to divest certain prepaid wireless assets to satellite provider Dish.
The expectation was that Dish would subsequently create its own cellular network and maintain the number of competitors in the market.
Even as of the present date, the merger is criticized frequently as one of the worst, anti-competitive acquisitions that was approved and later resulted in widespread price increases from reduced competition, i.e. greater pricing power from market leadership and the limited number of market participants.
Horizontal Integration vs. Vertical Integration
In contrast to horizontal integration, vertical integration refers to a merger among companies at different levels of the value chain, e.g. upstream or downstream activities.
The companies involved in vertical integration each have their own unique role at different stages of the overall production process.
For instance, a car manufacturer merging with a producer of tires would be an example of vertical integration, i.e. the tire is a necessary input to the end product in a car production line.
The distinction between horizontal and vertical integration is that the former occurs among similar competitors, whereas the latter takes place between companies at different stages in the value chain.
Vertical Integration involves the merger of two or more companies that serve different functions in the supply chain. In such a case, the entire (or most) of the supply chain is controlled by the company. Thus, the company receives increased oversight and control over the internal processes, which should theoretically eliminate operating inefficiencies.
Vertical Integration – Merger Strategy
How Vertical Integration Works (Step-by-Step)
Vertical integration consists of a company taking control over at least two steps in a given value chain, such as the production, distribution, or selling of the finished good or service, as opposed to outsourcing certain tasks.
The vertical integration of a supply chain implies that each step of the process is owned and closely controlled by a combined entity.
If a company publicly announces its plans to control and own aspects of its supply chain rather than relying on external suppliers as it did in the past, the shift is called “vertical integration”.
Furthermore, the merged company possesses a greater proportion of the total market share , which directly causes its buyer power to increase and gives it more negotiating leverage over its suppliers and distributors.
The end goal for pursuing vertical integration is to streamline the operational process from start to finish, i.e. having more ownership over all of the various stages in a production process.
Companies often opt to outsource or rely on external 3rd parties in an effort to reduce spending, yet sub-par production and quality issues can cause real damage to the branding of the company and diminish the trust of their customer base.
Therefore, vertical integration consists of a company possessing ownership over most, if not all, stages of the production cycle, including the suppliers and distributors.
Pros/Cons of Vertical Integration
Normally, the supply chain process starts with purchasing raw materials from suppliers – followed by a wide range of potential steps depending on the context – until the final product reaches the customer.
The strategy of vertical integration implies the company controls multiple stages in its supply chain, thereby reducing or even eliminating the need for reliance on any third parties.
Vertical integration can result in the production process becoming more efficient with reduced costs (and higher profit margins ).
The drawback, however, is that there is a great number of initial costs that are required to build the infrastructure and purchase the necessary equipment. Until the company recoups the initial cost, the integration would remain unprofitable.
Ownership of the supply chain from start to finish might initially sound appealing, but more control over the process does not necessarily result in higher quality.
While factors such as communication may be improved, the management team must have a thorough plan in order to be capable of managing every step of the production process.
Having an inept management team responsible for overseeing the complex supply chain can be very risky.
Vertical Integration Example: Electronics Supplier Acquisition
Suppose an electronics company decided to purchase a supplier that they have worked closely alongside in the past, and those suppliers’ parts (and components) are crucial inputs to the device.
If the electronics company decides to purchase the supplier to reduce manufacturing costs and streamline its operations, the acquisition would be an example of vertical integration.
Additionally, another example of vertical integration includes purchasing trucks and fleets of vehicles to transport the parts, i.e. the company is now in control of the entire distribution process.
Types of Vertical Integration: Forward vs. Backward Integration
There are two types of vertical integration:
Forward Integration → When an acquirer moves downstream; i.e. the company’s acquisition target moves them closer to the end customer, e.g. distributor or technical support.Backward Integration → When an acquirer moves upstream, the company is purchasing suppliers or product manufacturers (that are further away from the end customer).
A company undergoing backward integration is shifting its ownership and control of the process to an earlier point in the supply chain, whereas a company pursuing forward integration is moving forward to own and control the production stages that interact more closely with the end customers, such as the distribution process.
Vertical Integration vs. Horizontal Integration
Horizontal integration refers to a merger where competitors are combining their operations (and asset base) to benefit from economies of scale , increased buyer power over suppliers and vendors, and expanding their reach into new geographical locations (and end markets).
The differentiating factor between horizontal integration and vertical integration is that horizontal integration is the merger of close competitors operating in the same market.
On the other hand, vertical integration is between companies operating at different stages in the value chain and with distinct responsibilities in the production cycle.
In contrast to horizontal integration, vertical integration consists of a merger involving companies functioning at various levels of the value chain, such as either upstream or downstream activities.
Each company engaged in vertical integration has its own unique role at a specific stage of the production process.
A Reverse Merger occurs when a privately-held company acquires a majority stake in a publicly-traded company. A reverse merger – or “reverse takeover” – is most often undertaken to bypass the traditional initial public offering (IPO) process, which can be time-consuming and costly.
Reverse Merger Transaction Process
In a reverse merger transaction, a private company obtains a majority stake (>50%) in a public company to gain access to the capital markets while circumventing the traditional IPO process.
Usually, the public company in a reverse merger is a shell company, meaning that the company is an “empty” company only existing on paper and does not actually have any active business operations.
Nevertheless, there are other instances in which the public company does indeed have ongoing day-to-day operations.
As part of the reverse merger, the private company acquires the publicly-listed target company by exchanging the vast majority of its shares with the target, i.e. a stock swap.
In effect, the private company essentially becomes a subsidiary belonging to the publicly-traded company (and is thereby considered a public company).
Upon completion of the merger, the private company obtains control over the public company (which remains public).
While the public shell company remains intact post-merger, the private company’s controlling stake enables it to take over the consolidated company’s operations, structure, and branding, among other factors.
Reverse Mergers – Advantages and Disadvantages
A reverse merger is a corporate tactic utilized by private companies seeking to “go public” – i.e. become publicly listed on an exchange – without formally undergoing the IPO process.
The primary advantage for a company to pursue a reverse merger instead of an IPO is the avoidance of the onerous IPO process, which is lengthy and costly.
As an alternative to the traditional IPO route, a reverse merger can be perceived as a more convenient, cost-efficient method to obtain access to the capital markets, i.e. public equity and debt investors.
In theory, a well-executed reverse merger should create shareholder value for all stakeholders and offer access to the capital markets (and increase liquidity ).
The decision to undergo an IPO can be adversely affected by changing market conditions, making it a risky decision.
In contrast, the reverse merger process is not only significantly more cost-effective but can also be completed in a matter of weeks since the public shell company is already registered with the U.S. Securities and Exchange Commission (SEC).
On the other hand, reverse mergers have various risks, namely the lack of transparency.
The drawback to an expedited, quick process is the reduced time to perform due diligence, which creates more risk stemming from overlooking certain details that can turn out to be costly mistakes.
In a limited time frame, the companies involved (and their shareholders) must conduct diligence on the proposed transaction, but there is a significant time constraint for all parties engaged.
Moreover, the takeover of a private company is not always an easy process, since the existing stakeholders could oppose the merger, causing the process to be prolonged from unexpected obstacles.
The final disadvantage relates to the share price movement of the private company following the merger.
Given the limited time to conduct diligence and the reduced amount of information available, the lack of transparency (and unanswered questions) causes share price volatility , especially right after the transaction closes.
Reverse Merger Example – Dell / VMware
In 2013, Dell was taken private in a $24.4 billion management buyout (MBO) alongside Silver Lake, a global technology-oriented private equity firm.
Approximately three years later, Dell acquired storage provider EMC in 2016 for roughly $67 billion in a deal that effectively created the largest private technology company (renamed “Dell Technologies”).
Following the acquisition, the portfolio of brands included Dell, EMC, Pivotal, RSA, SecureWorks, Virtustream, and VMware – with the controlling stake in VMware (>80%) representing a crucial part of the reverse merger plans.
A couple of years thereafter, Dell Technologies began to pursue options to return to becoming a publicly listed company, offering a path for private equity backer Silver Lake to exit its investment.
Dell soon confirmed its intention to merge with VMware Inc, its publicly-held subsidiary.
In late 2018, Dell returned to trade under the ticker symbol “DELL” on the NYSE after the company repurchased shares of VMware in a cash-and-stock deal worth around $24 billion.
For Dell, the reverse merger – a complicated ordeal with several major setbacks – enabled the company to return to the public markets without undergoing an IPO.
In 2021, Dell Technologies (NYSE: DELL) announced its plans to complete a spin-off transaction involving its 81% stake in VMware (VMW) to create two standalone companies, marking the completion of Dell’s initial objective and the decision to now operate independently for the best interests of all stakeholders.
A Conglomerate Merger is the combination of two or more companies that each operate in distinct, seemingly unrelated industries.
A conglomerate merger strategy combines several different businesses, so the companies involved are not in the same industry nor direct competitors, yet potential synergies are still expected.
Conglomerate Merger Strategy in Business
The conglomerate merger strategy involves the combination of various different businesses with minimal operational overlap.
A conglomerate is defined as a corporate entity comprised of several different, unrelated companies, each having their own unique business functions and industry classifications.
Conglomerates are formed from conglomerate mergers, the combination of numerous companies that operate in different industries.
The merger occurs among businesses unrelated to each other, yet conglomerate mergers can still result in several strategic benefits to the consolidated entity.
Often, the anticipated synergies from such a merger become more apparent in periods of economic slowdowns.
Types of Conglomerate Mergers
Pure vs. Mixed Conglomerate Merger Strategy
In a horizontal merger , companies that perform the same (or closely adjacent) business functions decide to merge, whereas similar companies with different roles in the supply chain merge in a vertical merger .
In contrast, conglomerate mergers are unique in the sense that the companies involved perform seemingly unrelated business activities.
At a glance, the synergies might be less straightforward, yet such mergers can result in a diversified, less risky overall company.
Conglomerate mergers can be distinguished into two categories:
Pure Conglomerate Mergers → The overlap between the companies combined is practically nonexistent, as the commonalities are minimal even from a broad perspective.Mixed Conglomerate Mergers → On the other hand, the mixed strategy involves companies where the functions are still different, but there are still a couple of identifiable aspects and shared interests, such as the expansion of their product offerings.
In the former, the companies post-merger continue to operate independently in their own specific end markets, while in the latter, the companies are different but still benefit from the extension of their overall reach and branding, among other benefits.
While the independent nature of the merger might seem like a drawback, it is precisely the objective of the transaction and where the synergies are derived from.
Conglomerate Merger Benefits
Diversification Benefits → The strategic rationale for a conglomerate merger is most often cited to be diversification, wherein the post-merger company becomes less vulnerable to external factors such as cyclicality , seasonality, or secular declines.Less Risk → Considering there are now multiple different lines of businesses operating under a single entity, the conglomerate is less exposed overall to external threats because the risk is spread across the companies to avoid over-concentration in one specific part of the company. For instance, one company’s lackluster financial performance could be offset by the strong performance of another company, upholding the financial results of the conglomerate as a whole. Often, the reduced risk in the combined entity is reflected in a lower cost of capital , i.e. WACC.More Access to Financing → The lower risk attributed to the post-merger company also provides numerous financial benefits, such as the ability to access more debt capital more easily, under more favorable lending terms. From the perspective of lenders, offering debt financing to a conglomerate is less risky since the borrower is essentially a collection of companies, rather than only one company.Branding and Expanded Reach → The conglomerate’s branding (and overall reach in terms of customers) can also be strengthened by virtue of holding more companies, especially since each company continues to operate as an independent entity.Economies of Scale → The increased size of the conglomerate can contribute to higher profit margins from the benefits of economies of scale , which refers to the incremental decline in the per unit cost from greater volume output, e.g. business divisions could share facilities, close redundant functions such as sales and marketing, etc.
Risks of Conglomerate Mergers
The primary drawback to conglomerate mergers is that the integration of numerous business entities is not straightforward.
The process can be very time-consuming, meaning that it can take years before the synergies begin to materialize and positively impact the company’s financial performance.
The combination of two businesses could also lead to friction caused by factors such as cultural differences and an inefficient organizational structure – with the source often being a leadership team that cannot effectively manage all the companies at once.
Most of the risks associated with these sorts of mergers are out of the control of the management team , such as the cultural fit between the companies involved, making it even more necessary for each additional integration process to be well-planned, as mistakes can be costly.
Sum-of-the-Part Valuation (SOTP) of Conglomerate Business
In order to estimate the valuation of a conglomerate, the standard approach is a sum-of-the-parts (SOTP) analysis, otherwise known as a “break-up analysis”.
The SOTP valuation is typically performed for companies with numerous operating divisions in unrelated industries, e.g. Berkshire Hathaway (NYSE: BRK.A).
Since each business division of the conglomerate comes with its own unique risk/return profile, attempting to value the entire company together is impractical. As such, a different discount rate should be used for each segment, and a distinct set of peer groups for each division is used to perform trading and transaction comps .
Completing the valuation on a per-business -segment basis tends to result in a more accurate implied value, rather than valuing the company together as a whole entity.
The conglomerate is conceptually broken up and each business unit is valued separately in a SOTP analysis. Once an individual valuation is attached to each piece of the company, the sum of the parts represents the estimated combined worth of the conglomerate.
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