Vertical Merger

Vertical Merger Definition

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

A classic example of a vertical merger would be between 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 dissimilar businesses, the mergerMergerMerger refers to a strategic process whereby two or more companies mutually form a new single legal venture. For example, in 2015, ketchup maker H.J. Heinz Co and Kraft Foods Group Inc merged their business to become Kraft Heinz Company, a leading global food and beverage firm.read more helped eBay to increase the number of transactions and proved a strategic decision overall.

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Explanation

A vertical merger is a combination of two or more companies that are into the same industry but produce 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.

There are many players 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. So why do companies get into such mergers?

Vertical mergers allow companies to use the synergies that ultimately help in operating efficiently, costs getting reduced, and business expansion. 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 mergerHorizontal MergerHorizontal mergers take place when two companies in the same industry merge. Typically, industry competitors seek such mergers for a variety of reasons, including increasing market share, achieving economies of scale, lowering competition, and so on.read more, which involves a merger between two or more companies creating competing products or providing competing services and operate in the same stage of the supply chain.

Example of Vertical Merger

Comprehensive Example 

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

The following are the key financial parameters of A:

Amount Rs. In 1,000,000

• Capital EmployedCapital EmployedCapital employed indicates the company's investment in the business, i.e., the total amount of funds used for expansion or acquisition and the entire value of assets engaged in business operations. "Capital Employed = Total Assets - Current Liabilities" or "Capital Employed = Non-Current Assets + Working Capital."read more – 200
• Net Sales – CSL – 100, Cl2 – 30, H2   – 20. Total = 150
• EBIDTA margin – 30%
• ROCE – 20%

100% of Salt procured from third party manufacturers which are 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 #1 – 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 incurredCost IncurredIncurred Cost refers to an expense that a Company needs to pay in exchange for the usage of a service, product, or asset. This might include direct, indirect, production, operating, & distribution charges incurred for business operations. read more 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 to further 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 #2 – 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, to set up a manufacturing unit of this size, the investment required would be Rs. 200 (‘000,000), and the gestation period of the commencement of operations would be 3 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 projectInvestment Through A Brownfield ProjectBrownfield investment is the capital invested in the existing infrastructure or production facilities to develop a new production line. It is common in foreign direct investments and initiated through lease, merger, or acquisition of a production division.read more instead of a greenfield project.

ROCE and IRRIRRInternal rate of return (IRR) is the discount rate that sets the net present value of all future cash flow from a project to zero. It compares and selects the best project, wherein a project with an IRR over and above the minimum acceptable return (hurdle rate) is selected.read more for greenfield project by A:

Say, EBITEBITEarnings before interest and tax (EBIT) refers to the company's operating profit that is acquired after deducting all the expenses except the interest and tax expenses from the revenue. It denotes the organization's profit from business operations while excluding all taxes and costs of capital.read more 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 valueTerminal ValueTerminal Value is the value of a project at a stage beyond which it's present value cannot be calculated. This value is the permanent value from there onwards. read more = 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 maintenance cost of the plant 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 synergyMerger SynergySynergy in M&A is the approach of business units that if they combine their businesses by forming one single unit and then working together to achieve a common goal, the total earnings of the business can be greater than the sum of the earnings of both businesses earned separately, and the cost of the merger can be reduced.read more benefit could be seen in significantly improved IRR for a project when implemented along with C instead of A doing it alone.

Example #3 – Merger Leading to Diversification of Sourcing Risk of Raw Material

The major raw material – Industrial grade salt is procured by A in the market, and the production of CSL by A is entirely dependent 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 while during peak season, the salt is available in abundance and prices are low whereas, during offseason of salt production, the prices paid by A are very high. Also, in the case of no salt available in the market, then A has to stop its CSL production. This leads to a loss of predictability and stability of the day-to-day profitability and cash flow.

A can here 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 its salt produced and a steady cash flow leading to a win-win situation.

Example #4– 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 better sales mixSales MixSales Mix is the share of various products or services to be sold in business with respect to its total sales and is one of the key decisions to be taken because demand and profitability vary from one product/services to another.read more in terms of further processing CSL into CSL Flakes and thereby increasing the sales realizations and profits.

Why Vertical Merger Happens?

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

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

Controversy in Vertical Mergers

Vertical mergers, like other business transactionsBusiness TransactionsA business transaction is the exchange of goods or services for cash with third parties (such as customers, vendors, etc.). The goods involved have monetary and tangible economic value, which may be recorded and presented in the company's financial statements.read more, comes with a controversial aspect as well. To start with, Anti-trust violation laws often come into play when such a merger is more likely to reduce the competition in the market. It can also be used by companies to block access to raw materials for other players in the supply chain and hence destroying the fair competition through unfair business practices. It also could be used by companies to collude to gain an economic advantage in the supply chain.

Conclusion

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 integrationVertical IntegrationVertical integration is a corporate approach to take charge of its value chain or supply chain functions. It is the process of holding and managing the distributors, suppliers and retail locations at the company's discretion.read more to gain the edge over the competitors is not illegal but 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 has to offer and weighing it against the challenges or consequences it may pose, it still looks a pretty strategic way to expand and operate efficiently.

It uses purely depends on the intention of the merging companies as it could be used to kill the competition and control the players at different stages of the supply chain. Though Anti-trust laws are there in place to put a check to collusion and unfair trade practices like reducing the competition to a bare minimum in order to control the market, still companies do it using vertical merger.

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