I find it somewhat puzzling that horizontal M&As greatly outnumber vertical M&As. Assuming a 25% takeover premium, it’s not hard to see why most acquisitions fail to add value to the acquirer. There simply isn’t often 25% in value from rationalising shared costs.
The equation is significantly different for vertical integrations. Firstly, in addition to the costs benefits made possible through the rationalisation of both Admin and sales costs, there is the added benefit of improved ‘supplier’ relations and the ability to better utilise existing infrastructure.
Perhaps the best example of a successful vertically integrated company is Samsung. While they are now a leader in consumer electronics, they started off as an electronic component supplier. Through using their own components, they can now make great value TVs and smartphones with good margins.
Take an example of a wholesaler acquiring a retailer. Let’s say that both the retailer and wholesaler operate on 30% margins and that the existing cost to the wholesaler for distributing goods is 15%. Because of improved economies of scale and the ability to better utilise existing infrastructure, the additional cost of distributing goods to the newly acquired retailer is likely to be between 5% and 10%. If the retailer were to use the wholesaler as a cost centre, the effective margin on the products it buys will be 5% to 10%, not 30%.
Depending on the percentage of products the retailer can reasonably buy without harming turnover of the retail business, the effective margin for the retailer will increase from 30% to over 40%. As operating costs for the retailer will largely remain the same, the overall profit from the retailer will almost double (assuming the retailer’s cost of distributing goods is 15%).In this simplistic example, it is clear that the acquisition will increase value by substantially more than 25%.
To bring this all back to reality, the example used assumed that the retailer didn’t buy any existing goods from the wholesaler and that making the wholesaler the preferred supplier wouldn’t cause any disruption to the business. This is obviously not always the case. For this very reason, vertical integrations will work best is highly commoditised industries where goods or services can be readily substituted. Where this is the case, vertical acquisitions should be highly profitable