Vertical Merger

Vertical merger refers to the merger between two or more business units that operate at different stages of production along with the same industry where one is the manufacturer of the product and The other is the supplier of the raw material or services required to produce such a product.

Both the companies merging for better productivity belong to the same supply chain and their activities and functions are interdependent. By combining as one entity for production, both parties agree to cut costs, undergo expansion, enhance profitability, and have better goals to achieve collectively.

• Vertical merger refers to merging two or more business units that run at distinct production levels with a similar industry. The product's manufacturer and the raw material or services supplier needed to make a product.
• Some reasons for a merger include a cutback in operating costs, soaring margins and profits, reasonable quality control, better information flow management, and merger synergy, i.e., operating, financial, and managerial synergies.
• Companies may use it to obstruct access to raw materials for other supply chain players, end fair competition through illegal practices, and cooperate to benefit from the supply chain.

A vertical merger combines two or more companies into the same industry but produces different products or services along the value chain. It provides a strategic tool for companies to grow their businesses and acquire more control over the steps supporting the supply chain.

Many players are involved in a supply chain, mainly including suppliers who provide the raw materials, manufacturers produce the product, distributors then provide it to the retailers who finally sell the product and services to the end customers.

Competition is healthy for consumers as it allows the companies to brainstorm and provide innovative, high-quality products and services to the end-user. Though using vertical integration to gain the edge over the competitors is not illegal, using it to control the market by shady business practices like controlling the flow of raw material, etc., may come under the purview of law and is subjected to scrutiny in many countries. After looking at a variety of benefits the vertical merger offers and weighing it against the challenges or consequences it may pose, it still looks like a pretty strategic way to expand and operate efficiently.

It depends on the intention of the merging companies as it could use it to kill the competition and control the players at different stages of the supply chain. Though Antitrust laws are in place to check collusion and unfair trade practices like reducing the competition to a bare minimum to control the market, companies still do it using vertical mergers.

Vertical mergers allow companies to use the synergies that ultimately help operate efficiently, reduce costs, and expand the business. It also allows companies to grow their operations into different phases of the supply chain. The opposite of a vertical merger would be a horizontal merger, which involves two or more companies creating competing products or providing competing services and operating in the same stage of the supply chain.

A classic example of a vertical merger would be eBay and PayPal in 2002. eBay is an online shopping and auction website, and PayPal provides services to transfer money and allow users to make online payments. Though both eBay and PayPal were operating in different businesses, the merger helped eBay increase the number of transactions and proved a strategic decision overall.

The supply chain consists of vertically arranged multiple elements that stay connected from the production to the distribution of the products. Hence, the mergers can either happen from forward or backward. Based on this possibility, the vertically-styled mergers are divided into two types:

Backward Vertical Merger

This is a form of merger in which the component that is toward the last end of the chain merges with the entities toward the front. It is a backward merger where the entities merge with the manufacturing units to ensure they have control over the manufacturing part.

For example, let us say there is a company that buys different parts of the computer from different manufacturers and assembles it as its own system for sale. In this scenario, the latter merges with the manufacturing companies and takes control of the end product completely, ensuring cost-cutting to a significant extent.

Forward Vertical Merger

This is the segment in which one entity, which is toward the front, merges with the entity that is toward the end. This signifies the forward movement of the party to merge with the firms that take care of the distribution or sale activities.

For example, when goods and services reach retailers to be distributed to companies, the manufacturers willing to have their own distribution channels for the sale of their goods, merge with the retailers and distributors.

This type of merger creates value for the merged business worth more than the separate businesses under individual ownership. The rationale behind a vertical merger is to increase a single business entity's synergy and operating efficiency.

Some reasons for such a merger could be as follows:

• Reduction in operating costs
• Higher margins and profits
• Better quality control
• Better management of information flow
• Merger Synergy - Operating, Financial as well as Managerial Synergies

While there are lots of guidelines for the companies looking forward to a merger to follow. However, for vertical mergers, the point that must be taken into consideration is that such mergers must not create market structures that foreclose competition. This is because these mergers restructure the distribution chain to a great extent, leading to 50% restructuring, which lessens competition to a greater extent.

Vertical mergers, like other business transactions, also come with a controversial aspect. To start with, Antitrust violation laws often come into play when such a merger is more likely to reduce the competition in the market. Companies can also use it to block access to raw materials for other supply chain players and hence destroy fair competition through unfair business practices. Companies could also use it to conspire to gain an economic advantage in the supply chain.

Let us consider the following examples to understand what is vertical merger and how it works and benefits the parties involved:

Example #1

A good example of a vertical merger would be a car manufacturing company merging with a tire company.

It would not only benefit by reducing the cost for the automaker but also help expand the business by supplying the tires to other car manufacturers. So this type of merger will make the profit margins better by reducing the costs and boosting the top line, i.e., the revenue through business expansion.

Example #2

Company A is a manufacturer of inorganic chemicals viz caustic soda lye (CSL) with the byproducts of Hydrogen (H2) and Chlorine (Cl2). The primary raw material for the manufacturing of CSL is Industrial Grade Salt, which is called sodium chloride (NaCl). Hydrogen and Chlorine can be further processed into Hydro-Chloric Acid (HCL). CSL can be further processed into CSL Flakes and sold in the market with higher realizations.

The following are the key financial parameters of A:

Amount Rs. In 1,000,000

• Capital Employed – 200
• Net Sales – CSL – 100, Cl2 – 30, H2   – 20. Total = 150
• EBIDTA margin – 30%
• ROCE – 20%

100% of Salt is procured from third-party manufacturers, manufactured in a season of March to October.

EBIDTA margin on Cl2 and H2 is negative 10% due to a lack of market demand. A does not have an efficient sales team.

With the above profile of A, let's see various vertical mergers the company can look into with companies in the same industry of inorganic chemicals:

Example 3 - Merger Leading to Improvement in EBIDTA Margins

Company B is a manufacturer of HCL with a turnover of Rs. 40 Cr per annum. B procures H2 and Cl2 from the market at the cost equivalent to 50% of sales of HCL. Further processing cost incurred is 40% of sales, and thereby B makes an EBIDTA margin of 10%.

Here A and B can merge with which B will get raw material viz H2 and Cl2 from A at production cost, which is lower when purchased from the market, thereby margin increase to 15% and A will be able further to process H2 and Cl2 into profitable product HCL and thereby improving overall profitability.

EBIDTA margins will thus shape as below:

Before the Merger

After the Merger

Example 4 – Merger Leading to a Reduction in Costs and Improvement in ROCE

Let us say Company C is in the manufacturing of Caustic Soda Lye. The company has a very good sales and marketing team. However, C could not increase production due to a lack of funds and process expertise to implement a project for production expansion. C could expand production at an existing site by 30000 MT per annum with an investment of Rs. 100 (‘000,000) and gestation period of 1 year.

For A, the investment required would be Rs to set up a manufacturing unit of this size. 200 ('000,000), and the gestation period of the commencement of operations would be three years.

Here it makes a good opportunity for A and C to get into a vertical merger and gain economies of scale of size and savings in investment through a brownfield project instead of a greenfield project.

ROCE and IRR for greenfield project by A:

Say, EBIT per annum for 30000 MT plant would be Rs. 40 (‘000,000). A has to spend extra on marketing to sell the higher production, say Rs. 5 (‘000,000) per annum.

ROCE per annum for A would be 35/200 = 17.50%.

Terminal Value

• Terminal value = Last projected FCF * (1+Growth rate) / (WACC – Growth rate)
• The growth rate is assumed to be 0, WACC at 15%.

Terminal value = 35/0.15

Terminal Value = Rs. 233 ('000,000)

IRR will be - 

IRR = 13.95%

ROCE and IRR for brownfield project with C:

C will not have to spend extra on marketing costs. However, the plant's maintenance cost would be high, viz Rs. 10 (‘000,000) per annum due to the poor design of the existing plant and to hire expertise from outside for running the plant. EBIT would be Rs. 40 – 10 Cr = Rs. 30 (‘000,000)

ROCE per annum would be 30/100 = 30%.

Terminal Value

IRR will be - 

IRR = 34.86%

Thus merger synergy could be seen in significantly improved IRR for a project when implemented along with C instead of A doing it alone.

Example 5 - Merger Leading to Diversification of Sourcing Risk of Raw Material

The main raw material – Industrial grade salt is procured by A in the market, and the production of CSL by A entirely depends on the availability of salt in the market. A has to buy salt at any price; it can procure and has no bargaining power due to its dependability.

Thus, during peak season, the salt is available in abundance, and prices are low, whereas, during the off-season of salt production, A's prices are very high. Also, in the case of no salt available in the market, then A has to stop its CSL production. It leads to a loss of predictability and stability of the day-to-day profitability and cash flow.

A can enter into a vertical merger with companies having salt fields producing salt and thereby get assured sourcing of its raw materials. Further, the salt-producing companies can also get an assured supply chain for their salt production and a steady cash flow leading to a win-win situation.

Example 6– Merger Leading to Improvement in Sales Mix and Realizations

A is producing CSL, which has a realization of Rs. 35000 per MT. CSL can be further processed into CSL flakes with the realization of Rs. 45000 per MT. The cost of further processing is Rs. 5000 per MT.

Company D is manufacturing CSL and CSL Flakes. However, due to the lower production of CSL, the CSL Flakes capacity is lying idle for D.

This situation provides the idle opportunity for a vertical merger of A and D, leading to a better sales mix in further processing CSL into CSL Flakes and thereby increasing the sales realizations and profits.

Vertical merger offers a lot of benefits to the parties involved in the merger. Whether a backward or forward merger, it emerges to be efficient in most cases. However, this arrangement has a set of demerits as well, which the parties must know before they opt for such mergers.

Let us have a quick look at the pros and cons of this type of merger:

Benefits

• The cost-cutting that entities perform ultimately makes products available at cheaper rates to consumers.
• Mergers give access to new finances to both parties as they become one.
• Restructuring of a company becomes easy as per technological and innovative knowledge and expertise.
• The supply chain or the whole network becomes more streamlined.

Limitations

• The operating costs are higher as the merger leads to the hiring of new people and the deployment of new tools and machinery.
• Different work cultures merge, which might lead to certain differences in points of view.
• It is likely for key employees to leave in case they do not get the same working environment.

Both these terms play an important role in the context of mergers and acquisitions (M&A). Hence, it is important to list down the differences to understand them individually. Let us have a look at their comparison below:

• Vertical mergers signify the combination of two companies, forming different elements of the same supply chain and belonging to the same market. On the contrary, horizontal mergers indicate two companies belonging to the same market, combining their functions.
• The former occurs when one party desires to take control over some other stage of production or increase efficiency, while the latter occurs to cut competition.

This article has been a Guide to Vertical Merger and its definition. We explain its examples, vs horizontal mergers, guidelines, advantages, disadvantages, and types. You may learn about from the following articles-

• Merger and Acquisitions Types
• Vertical Merger Examples
• Statutory Merger