When to Vertically Integrate
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Transcript of When to Vertically Integrate
L E K . C O ML.E.K. Consulting / Executive Insights
EXECUTIVE INSIGHTS VOLUME XV, ISSUE 9
INSIGHTS @ WORKTM
Valid Reasons to Vertically Integrate
While there are many reasons to vertically integrate, three are
most common:
• Fixingavalue-chainweakness
• Leveragingavalue-chainsegmentstrength
• Increasingmarketpowerorreducingcyclerisk
Fixing a Value-Chain Weakness
Attimesakeyelementofthevaluechainsimplyisnotworking.
PepsiCoinitiatedastrategytoacquirebottlersinpartbecause
bottlerswerefocusingonhigh-volume,high-profitcarbonated
softdrinksratherthannewproducts.PepsiCo,recognizingthe
decliningpopularityofcarbonatedsoftdrinks,neededitsbot-
tlingchanneltofocusonsmallerbutgrowingsegments.One
buildingproductsbusinesshasrecentlyembarkedonastrategy
ofacquiringdistributorsbecausetheybelievethattheirindepen-
dentdistributorsarenotaggressivelydevelopingtheirmarkets.
When to Vertically Integrate was written by Chris Kenney, Managing Director and Head of L.E.K. Consulting’s North American Basic Industries Practice, and Robert Rourke, Managing Director at L.E.K. Consulting. L.E.K. Consulting Managing Directors Lucas Pain and Aaron Smith assisted in the drafting of the whitepaper and key research support was provided by L.E.K. Consulting’s Basic Industries Specialist, Maria Gacek. Please contact us at [email protected] for additional information.
Verticalintegration—whetherupstreamordownstream—is
awell-understoodandacceptedstrategytocapturevalue.
Motivationsarevaried.Companiesmaydesiretobettersecure
criticalsuppliesorexertgreatercontroloveradysfunctional
downstreamchannel.Specificcircumstancesmustexistinorder
forthesemotivestoultimatelytranslateintovaluecreation.
Despiteitswidespreadacceptance,verticalintegrationisalso
oneoftheriskieststrategiesinbusinessbecauseitoftenin-
volvesenteringintoactivitieswithsuccessfactorsandeconom-
icsthatarequitedifferentfromthecorebusiness.Downstream
integrationraisestheprospectofcustomerconflictsofinterest
(i.e.customersperceiveyouasacompetitorontheirturf).Up-
streamintegrationcanresultinthecaptivesupplierlosingsales
thatithadpreviouslybeenmakingtoyourcompetitorsandit
canalsolimityoursourcingflexibility.
L.E.K.Consultinghashelpedmanyclientsthinkthroughthe
meritsofverticalintegrationandweofferthefollowingcase-
basedguidanceasyouweightherisk/returnofupstreamand
downstreamacquisitions.
When to Vertically Integrate
While vertical integration is a common strategy to secure distribution channels and boost profitability, it can expose
a company to significant risk.
L.E.K. Consulting has reviewed common vertical integration scenarios and the factors that underlie success in each case.
EXECUTIVE INSIGHTS
L E K . C O MINSIGHTS @ WORKTMPage 2 L.E.K. Consulting / Executive Insights Volume XV, Issue 9
EXECUTIVE INSIGHTS
Inotherinstances,upstreammanufacturersareforcedto
forwardintegrateoutofnecessity.Lastyear,ArmstrongWorld
Industriesannouncedthesaleofanownedflooringdistributor.
TheCEOofArmstrong’sFlooringDivisionsaid,“Ifyourecall,we
gotintothedistributionbusiness….outofnecessitywhenour
majordistributor...wentoutofbusiness.”TheArmstrongWorld
IndustriesCEOadded,“Wearenotinthedistributionbusiness.
[Manufacturinganddistribution]aretwovery,verydifferent
businessmodels.Myexperienceisyoucandooneofthose
well,soyouareeitherreallygoodatthedistributionbusinessor
youareareallystrongmanufacturer.”1
Inyetotherinstances,companieshavelimitedaccesstoattrac-
tiveindependentchannelsandsoforwardintegratetoachieve
thisaccess.Goodman,amanufacturerofHVACequipment,
realizedthatattractivedistributorswerealreadytiedupin
exclusiverelationshipswithlargercompetitors.SoGoodman
embarkedonastrategyofbuyingandbuildingitsowncaptive
HVACdistributionchanneltogaingreatermarketaccess.Good-
man’sevolutionfromasubscaleplayertoamarketleaderin
residentialHVACequipmentislargely(butnotsolely)theresult
ofthisstrategy.
Theproblemcanalsolieupstream.Forexample,acompany
mayacquireasuppliertoreduceuncertaintiesinsupply,or
becausethecostofsupplyfailureisunacceptable.Boeing
purchasedkeycomponentsuppliersfortheDreamlinerinorder
toaddressdeliveryproblems.Nucor,asteelmanufacturer,pur-
chasedascrap-metalbrokertosecureavitalsupplysource.
Whenusingverticalintegrationtofixavaluechainfailure,four
conditionsmustexist:
1. Transactionsbetweenthepreviouslyindependent
partiesmustbefrequent,ofhighvalueorstrategically
important.
2. Thetransactionsmustbesub-optimalintermsofcost,
time,reliability,quality,etc.priortointegration.
3. Integrationpromisestoreducetimeorcost,orpromises
toimproveeffectiveness.
4. Channelconflict(i.e.competingwithexistingcustom-
ers)mustbeminimalormanageable.
Leveraging a Value-Chain Segment Strength
Inadditiontoaddressingsupply-chainweaknessesorrisks,ver-
ticalintegrationcanalsoapplyakeystrength.Yearsago,when
SherwinWilliamswassolelyapaintmanufacturer,thecompany
embarkedonastrategyofbuildingoracquiringretailpaint
stores.Thecompanynowownsmorethan3,000storesacross
NorthAmerica,anextremelystrongpositioninaretailchannel
thatusedtobehighlyfragmented.SherwinWilliam’sstrategy
succeededbecauseofitsstrongbrandpositionwithDIYand
contractorcustomers.AppleInc.’sretailstrategyrepresents
anotherexampleofleveragingbrandstrengthdownstream.
Acompanycanalsoapplystrengthsinareasotherthanbrand
position.Forexample,firmsmaycompeteonthebasisofprod-
uctbreadth.Companieswiththebroadestproductrangemay
findanindependentdistributor’svaluepropositionweakerin
contrast.TaketheexampleofDal-Tile,aleadingmanufacturer
oftileproducts.Theyofferanextremelybroadproductlineand,
whiletheyalsosellthroughindependentdealers/retailers,they
maintainmorethan250company-ownedoutlets.Theseinclude
Dal-Tiledealers,designcentersandstoneshowrooms.
Toensurethatthisstrategicpathmakessense,companies
shouldlookforthefollowingconditions:
1. Anassetorcapabilitythatyoucontrolisuniqueand
competitivelydifferentiated.
2. Thisassetcanbeappliedtoeitheranupstreamor
downstreamportionofthevaluechain.
3. Thevalueofapplyingthisassettoanothersegment
ofthevaluechainsignificantlyoutweighstraditional
risksofverticalintegration(learninganewbusiness,
customerconflict,etc.).
1Sources:CentralPennsylvaniaBusinessJournal,September6,2012andArmstrongWorldIndustriesEarningsConferenceCall,October31,2012
EXECUTIVE INSIGHTS
L E K . C O MINSIGHTS @ WORKTML.E.K. Consulting / Executive Insights
Increasing Market Power or Reducing Cycle Risk
Verticalintegrationcanalsobeusedtoimproveindustrystruc-
tureorcorrectexposuretocyclicality.Companiesthatpursue
integrationinthisscenariousuallyhavesomecombinationof
thefollowingcharacteristics:
1. Highlycyclicaldemandmarkets.
2. Capital-intensiveandhighfixed-costupstreamassets;
capacityutilizationisakeydriver.
3. Highlyspecificassetsthatcannotservediversemarkets.
4. Upstreamactivitiesaresignificantlymoreprofitablethan
downstreamactivities.(Needtodefendhigherup-
streamprofitsbyexertinggreaterdownstreamcontrol).
5. Highlyconcentratedupstreamordownstreamsupply
channels.(Thismeansthatverticalintegrationstepswill
captureareasonableportionoftheupstreamordown-
streammarket).
Downstreamverticalintegrationcanmateriallyimprovemarket
power.Tounderstandwhy,consideranindustrywithfoursup-
pliersandfourcustomers.Eachcustomercannegotiateacross
foursupplierstosecurethebestdeal;however,iftwosuppliers
acquiretwocustomers,thenumberofremainingsuppliersis
criticallylow.Inthiscase,halfofthecustomersarecaptiveto
twosuppliersandtheremainingcustomershaveonlytwo
independentsourcesremainingwhichwouldinturnlikely
causetheothersupplierstobelievetheyhavemorepricing
power–whichinturnincreasesthepricingpowerofthe
verticallyintegratedplayers.
Verticalintegrationcanalsohelpcompaniesbetterridethe
wavesofbusinesscycles.Inmarketswheresupplyistightand
pricesarerising,theintegratedplayercanfullyparticipate
inmoreofthedownstreamprofitpool.Whenmarketsare
softandpricesarelower,theintegratedplayercansubsidize
downstreambusinesstogainsharewhilemaintainingupstream
(i.e.moreprofitable)volumes.Thisstrategy,inourexperience,
workswellacrossmostpartsofaneconomiccycle–otherthan
therecentconstructioncyclewhenindustryutilizationdropped
tounprecedentedlevelsofeconomicactivity.Inthatenviron-
ment,boththeupstreamanddownstreamfailedtoearnback
costofcapitalandthestrategyacceleratedshareholder-value
destruction.Clearly,thisstrategyrequiresaconservativebalance
sheetandisnotforthefaintofheart.
Insituationswheretherearelargerplayersinamoreconsoli-
datedupstreamportionofthevaluechain,theremayalso
beopportunitiestoimproveefficiencyandprofitabilityina
fragmenteddownstreamenvironmentbyconsolidatingdown-
streamassets.Inheavymaterialsbusinesseswherefreightand
distributioncostscanbehigh,havinglocaldownstreamscale
canimproveoperationalefficiencyandprovideadvantagesover
smaller-scaleindependentplayers.
Companiespursuingverticalintegrationinanattemptto
increasemarketpowerorreducecycleriskcanbeseenacross
manyheavymaterialandcommoditycategories.Forexample,
themajorcementcompanies(e.g.Holcim,Cemex,etc.)have
successfullyverticallyintegratedintodownstreamredi-mix
cementoperationsinmanymarkets.Anothersectorwhere
downstreamverticalintegrationisevidentiscorrugatedpackag-
ing.CorrugatedmaterialplayerslikeSmurfitKappa,Boiseand
othersarepursuingastrategyofacquiringdownstreamplayers
inordertobettermanageefficienciesandstabilityacrossthe
valuechain.
Conclusion
Channelpartnersandsupplierscanbevitalalliesinamanufac-
turer’squesttocreatevalue.However,theserelationshipsare
rarelyperfectanditcanbetemptingtoaddressimperfectionsin
downstreamorupstreamrelationshipsthroughacquisition.
EXECUTIVE INSIGHTS
L E K . C O MINSIGHTS @ WORKTMPage 4 L.E.K. Consulting / Executive Insights Volume XV, Issue 9
L.E.K.ConsultingisaregisteredtrademarkofL.E.K.ConsultingLLC.Allotherproductsandbrandsmentionedinthisdocumentarepropertiesoftheirrespectiveowners.
©2013L.E.K.ConsultingLLC
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INSIGHTS @ WORKTM
Asyourcompanyconsidersthispath,L.E.K.Consulting
suggeststhatyouconsiderthreekeypoints:
• ExamineNon-IntegratedBenefitsCarefully:While
youfocusonintegrationbenefits,makesureyoualso
focusonpotentiallosses.Willyournewcaptivesupplier
losesalespreviouslymadetocompetitors?Howwill
yoursteptoacquireacustomerbeviewedbyyour
othercustomers?
• ConsiderNewKeySuccessFactors:Muchoftherisk
involvedinverticalintegrationarisesastheacquirer
entersanewbusinessthatrequiresverydifferent
expertise.Forexample,amanufacturerthatpurchases
distributorsmustlearnthecriticalimportanceofworking
capitalmanagementandtheneedtovigorouslydefend
andexpanditsdistributorvalueproposition.
• ThinkAllianceFirst:Manyofthebenefitsofvertical
integrationcanbeachievedthroughanalliance.Inthe
process,youmayrequiremuchlesscapitalandbe
exposedtomuchlessrisk.Soifsupplystabilityisthe
objective,consideralongtermsupplyagreementor
evenajointventurearoundaspecificsupplysource
beforepursuinganacquisitionoftheentiresupplier.
Thevastmajorityofstrategicguidancepreachesthevirtuesof
focus.Expertssuggestthatyoufocuson“corecompetencies”
or“strategicmarketsegments.”Thestrategiclogicbehindver-
ticalintegrationcanruncountertothisadvicebyleadingyou
toapplycorecompetenciestodownstreamactivitiesorexpand
yourfocustoupstreamordownstreambusinesses.Indoing
so,beextremelycarefultoensurethatthebenefitsofthese
stepsoutweightherisksassociatedwithapotentiallydiffused
strategicfocus.