Vertical Integration Explained: How it Works (+ Examples)
Global supply chains have been chaotic for the past two years. Vertical integrations can be used to help companies better control their supply chains.
What is Vertical Integration?
Vertical integration is a type of transaction in which one company acquires another company at a different point in its supply chain (upstream or downstream), with the intention of consolidating its supply chain. Companies sometimes use vertical integration as a way to ensure readily available access to raw materials and limit dependence on outside suppliers.
How Vertical Integration Works
Vertical integration happens every time a company consolidates its supply chain. Most vertical integrations happen through capital acquisition.
So, for example, when Ford Motor Company built a plant at the River Rouge complex, the vertical integration happened simply by Ford building next to a river, purchasing railroads and coal mines, and building a sawmill.
Types of Vertical Integration
There are generally three types of vertical integration (although the third is merely a mixture of the first two):
Acquiring companies or assets upstream in the supply chain. An example of forward integration is if a farmer purchases a trucking company that transports milk (a downstream distributor) to distribute produce to retail stores.
Acquiring companies or assets downstream in the value chain. An example of backward integration is store of retail chains acquiring a milk plant to produce its own-brand milk, or a shirt-maker acquiring cotton fields.
This is the case of a company in the supply chain acquiring forward and backward, to create a more ‘balanced’ vertically integrated company.
Vertical vs. Horizontal Integration
Vertical integration occurs when a company acquires a company or asset at a different part of the supply chain, and horizontal integration occurs when a company consolidates with a company or asset at the same point of the supply chain.
So, rather than a farmer buying a cheese maker as with vertical integration, in horizontal integration, the farmer would buy (or merge with) another farm. In both cases, there’s a benefit of scale that didn’t exist before the acquisition.
Advantages and Disadvantages of Vertical Integration
- Control over (sometimes rare) supplies.
- Reduced vulnerability to price swings in raw materials
- Better bargaining power with other levels of the supply chain
- Ability to budget better (from operational and financial perspectives)
- Companies often overpay in the expectation that the advantages will be enormous
- Vertical integration can, by its nature, kill value in the acquisition, owing to operational slack, lack of innovation, and competition
- Moving away from core competencies brings significant risks
- Vertical integration can attract the attention of anti-monopoly regulators (similar to horizontal integrations)
Vertical Integration and Business Profitability
There is no firmly established relationship between vertical integration and profitability. We are hardwired to believe that when a company owns its means of production - or a raw materials producer has acquired some means to sell their produce at a higher point of the value chain - that the end result will obviously be profit.
There is a strong rationale for this, but consider the following:
As with any M&A transaction, acquiring a company on the supply chain doesn’t automatically lead to ‘1+1=3’. Deals can destroy value as much as create it, and managers need to be cognizant of this before entering transactions.
Yes, it’s still important. Even if both companies are dealing with (quite literally) many of the same end customers, that doesn’t mean that the corporate cultures are the same, and misunderstanding this can set up culture clashes.
As we have alluded to, operations often slack when a company is guaranteed its output will be purchased in-house. Competitive edge and innovation tend to diminish. This can be a challenge even for good management.
Taking these into account, where is the opportunity for companies vertically integrating to do so profitably? The answer lies in understanding exactly how value is created at each point of the value chain. For example, on this same topic, PIMS Associates note:
“For businesses located in mature and stable markets, vertical integration (i.e. make rather than buy) generally impacts favorably on performance. In markets that are rapidly growing, declining, or otherwise unstable the opposite is true.”
According to PIMS, the logic appears to be that in markets characterized by little innovation (i.e. mature and stable markets) where the value chain is already well established, there will be strong opportunities to generate profitability in vertical integration.
The opposite is true for declining firms (where there is rarely an opportunity for profitability anyway) and rapidly growing firms, who may be better positioned to generate profit by staying agile, using available cash to fund their growth ambitions, and refusing to become an unwieldy mid-sized company.
Examples of Vertical Integration
Backward Integration: The Ford Motor Company at River Rouge, MI:
Much has been written about the first moving assembly line at the Ford Motor Company over 100 years ago. This is often seen as the birth of mass production. What is less discussed is how, for the production line to work in the way that Henry Ford had planned, the company needed to be completely vertically integrated.
The company basically acquired every single component needed to manufacture a car. Among other acquisitions, Ford purchased a coal mine to power its smelters, an iron mine to produce the metal, 700,000 acres of timberland for the wood used in car frames, freighters to bring ore from the mines, and even a glassworks plant for the glass used in his car windows. He even had a sales operation in place to ensure complete vertical integration. What could go wrong?
Well, as the section above on profitability discusses, operational slack becomes a problem at some point in vertically integrated companies. And so it was at Ford. Other car companies came along and ‘stole its lunch’ - notably Toyota, in the second half of the 20the century, which pioneered JIT (Just in Time) manufacturing, negating the need to be fully vertically integrated.
Forward Integration: Amazon’s acquisition of Whole Foods
In 2017, the world’s largest online retailer Amazon was looking to expand its presence in grocery purchases in the United States. For some time, grocery purchasing had been seen as the last great frontier of e-commerce. Many had tried it, but few had succeeded. Groceries, with their requirement for freshness, made the e-commerce move difficult.
Then, Amazon acquired upmarket grocery store chain Whole Foods for $13.7 billion which was considered a market-shifting vertical integration play. In possession of warehouses and distribution centers across the United States, the one thing Amazon lacked until this point was a physical retail presence. Amazon began embedding its technology in the retailer’s stores shortly after the transaction closed.
The acquisition of Whole Foods also gave Amazon insights into physical retail that they couldn’t easily have gained. Five years on, the company is now rolling out a series of Amazon Fresh stores across the United States. These smaller convenience stores are essentially another vertical integration move by Amazon, but with an acquisition of assets (i.e. the properties) rather than acquiring another company.
Balanced Integration: Facebook
Over the past twenty years, big technology firms have been among the most active of any industry segment, often in an attempt to acquire valuable IP or to gain a foothold in consumer spaces where they see huge growth (health tech being a recent example of this). For anyone looking for a balanced integration strategy (i.e. backward and forward integrations), look no further than Facebook.
Facebook’s big forward integrations over the past decade and a half are well-known: Instagram was acquired for $1 billion in 2012 and WhatsApp, was acquired for $19 billion in 2015. These are the customer-facing acquisitions and upstream buys. Facebook has made almost 100 acquisitions over this period, often in back-end software that underpins the customer-facing apps (i.e. backward integrations).
This is the essence of a balanced integration strategy - improving the supply chain (in Facebook’s case, Intellectual property, technology, and technology talent) to power the front end (in Facebook’s case, customer-facing platforms like Instagram, the videos that play on Facebook’s own platform, and WhatsApp messenger - the world’s most popular mobile communications tool).
Vertical Integration Strategies
The example of Facebook shows that, even in fast-growing industries, there can be a place for well-conducted vertical integration. Technology firms, arguably more than other firms, tend to see vertical integrations as a chance to build their teams and not just their assets.
This was well covered by Ailene Holderness, Head of M&A at IAC, in a recent podcast episode of M&A Science. IAC has built recognizable firmssuch as Tinder, Expedia, and Vimeo, to name a few.
"Risk taking should be rewarded. Institutions who embrace that can find people who can add a lot of value to their teams because they have done something outside of the box."
Also on M&A Science, Jerry Will, Vice President of Corporate Development at 3M, says that one issue underpins all vertical integration acquisitions at a company:
“At that top level, you need some sort of cohesive, consistent view in terms of how you go about generating value for customers in all those different markets. We spend a lot of time thinking about that.”
Notably, he states that customer value can be generated at any stage of the value chain.
What emerges from looking at tech firms and others is that strategy has to underpin vertical integration. Bringing a different part of the supply chain under the company umbrella is not going to generate value just because it’s owned by the company.
When considering vertical integrations, the key question to ask is not: “how will this reduce costs?” but rather, “will this transform our company?”
How DealRoom Unlocks Value in Vertical Integrations
Vertical integrations are no different to any other M&A transaction in that the due diligence phase is a demanding process where significant amounts of transaction value are created or destroyed.
DealRoom is an M&A project management tool which has been specifically designed to empower companies going through the process. Among the benefits we bring to companies working in vertical integrations are:
- Faster access to deal-relevant data to find and unlock synergies in the deal
- Collaborate with functional teams and deal counterparties
- Help develop thorough due diligence and post-close plans
- Provide expert-developed post-integration playbooks (30, 60, 100 days)
- Help to design day one and future operational plans for the newly created firm
- Put in place conditions for post-merger integration (PMI)
- Enable deal participants to envision strategies suggested by the data
- And much more, including all transactions, such as M&A integration, divestment, separation and other.
Transform your company, rather than simply reduce costs, and find out how to add more value to your transaction via a free demo today.