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 industrial@lek.com 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.

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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

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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.

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L E K . C O MINSIGHTS @ WORKTMPage 4 L.E.K. Consulting / Executive Insights Volume XV, Issue 9

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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.