Smith Holland M&A Resources
Vertical acquisitions for middle market companies.
In the world of mergers and acquisitions, there are numerous different types of middle market M&A strategies for both the buy side and sell side of the deal. For strategic acquirers, the term vertical acquisitions usually refers to a company buying one of their suppliers.
For example, if you look at the Coca-Cola company that makes the iconic Coke soft drink products, they made a strategic move many years ago to acquire the majority of the bottling facilities that package their soft drinks. This acquisition strategy is a perfect example of a vertical acquisition transaction. The company recognized that it would be more profitable if it owned a key piece of their supply chain and as a result, they made strategic acquisitions to realize a higher net profit through synergistic savings. While bottling facilities only represent one component of Coca-Cola’s overall supply chain, another example of a vertical acquisition for this company would be if they acquired one of the farms that they source their raw sugar from. With any business that sells durable goods or nondurable goods, there are always ingredients that go into making that product. When Coca-Cola, one of their main ingredients is sugar. With a business like Nike, one of the “ingredients” that goes into making their shoes is rubber. When a company acquires one of the businesses that they source their ingredients from, that’s the definition of a vertical acquisition. And while you may think the story of Coca-Cola’s vertical acquisition strategy of acquiring the bottling facilities ends here, in a surprising move, Cola-Cola has recently deployed a strategy that “refranchises” the bottling facilities back to independent ownership, essentially reversing the effects of their entire vertical acquisition strategy that took decades to fully complete.
Vertical acquisitions can have many financial benefits, most of which come from reducing waste by bring all operations under one umbrella company. While the primary goal for most vertical acquisitions is to reduce the company’s COGS by cutting out the supplier through an acquisition, there are often many additional cost synergies that can be realized through strategic vertical acquisitions. For example, if the bottling company being acquired by Coca-Cola had their own in-house legal department, eliminating that department entirely (and by extension, eliminating the those salary expenses) would be possible since Coca-Cola already has their own in-house legal team. It would be cost effective to keep both legal departments if the existing Coca-Cola legal team can handle all of the work that was previously being managed by the bottler’s legal team. These kinds of synergies can lead to higher net operating cash flows to be realized quickly following the closing since eliminating or combining redundant departments is usually not a capital-intensive process. And for a company that just completed a vertical acquisition, identifying and realizing cost savings through synergy revenue opportunities is a smart way to help offset the cost of capital used to fund the vertical acquisition.
While increasing efficiencies is usually central to the strategy behind most vertical acquisitions, it’s not always about the cost savings. In some cases, companies may be limited by the output capacity of their main supplier, which therefore limits their ability to grow internally. The manufacturing company might want to grow, but might be limited by the available credit facilities. Rather than waiting for their supplier to expand their manufacturing capacity output, the acquiring company could realize increased shareholder value by acquiring the manufacturer through a vertical acquisition. If the acquiring company has enough capital left over to expand the manufacturing facility that they just acquired, a vertical acquisition might make sense here as the company could realize higher revenue growth if they are able to increase the unit output by expanding the manufacturing facility. In this example, the motivations for the vertical acquisition are more focused on long-term growth and less about short term net profit since the company can only grow if their manufacturing partner grows. Instead of waiting for the manufacturing partner to decide to expand, the company can have better control over their ability to grow faster by acquiring the manufacturer through a vertical acquisition.
Most businesses rely on other businesses to facilitate the sale of goods or services being offered. As mentioned above, Coca-Cola makes the soft drink, but they use another company to actually package that product. Even businesses that are already vertically integrated still almost always rely on other companies to facilitate daily operations. For example, a simplistic company that makes wooden canoes by hand has only 2 inputs, which include raw wood and human labor (to shape the canoe from the raw wood). Even though this company grows their own trees for the raw wood materials, they still rely on companies like FedEx and UPS to actually get their products into the hands of customers. Taking this into consideration when starting a business can shape a company’s entire long-term strategy as we’ve seen plenty of companies that start out small, experience rapid growth and then acquire the company that plays the biggest role in their supply chain to have more control over future growth rates.
Another important benefit that can come from a vertical acquisition is mitigating the risk that your suppliers will raise prices. When suppliers raise prices, businesses often experience margin compression as it’s much harder to raise the prices that the consumers pay, especially in commodity type businesses. With endless news stories about the ongoing trade wars between the United States, Europe and China, and how that might impact the prices consumers pay, vertical acquisitions strategies are becoming increasingly more possible, even when both companies involved are based out of the same country. To avoid the risk of suppliers raising prices, which negatively impacts net profit margins, there can often be more operational risks for a business that has no plans to become as vertically integrated as possible.