Vertical Merger Definition Example How It Works

Vertical Merger Definition

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, theMerger 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 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 increase the number of transactions and proved a strategic decision overall.

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Explanation

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. So why do companies get into such 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 aHorizontal 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 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 two or more companies creating competing products or providing competing services and operating in the same stage of the supply chain.

Example of Vertical Merger

A good example of a vertical merger would be a car manufacturing company merging with a tire company. It would not only benefit in 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 marginsProfit MarginsProfit Margin is a metric that the management, financial analysts, & investors use to measure the profitability of a business relative to its sales. It is determined as the ratio of Generated Profit Amount to the Generated Revenue Amount. read more better by reducing the costs and boosting the top lineTop LineThe top line is the revenue earned by the business by selling goods or services, reported in the income statement for a defined period. read more, i.e., the revenue through business expansion.Profit Margin is a metric that the management, financial analysts, & investors use to measure the profitability of a business relative to its sales. It is determined as the ratio of Generated Profit Amount to the Generated Revenue Amount. read more

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 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 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 – 200Net Sales – CSL – 100, Cl2 – 30, H2 – 20. Total = 150EBIDTA 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 #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 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 #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, 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 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, WACCWACCThe weighted average cost of capital (WACC) is the average rate of return a company is expected to pay to all shareholders, including debt holders, equity shareholders, and preferred equity shareholders. WACC Formula = [Cost of Equity * % of Equity] + [Cost of Debt * % of Debt * (1-Tax Rate)]read more 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%.

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 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 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 #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 a betterSales 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 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 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 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 costsHigher margins and profitsBetter quality controlBetter management of information flowMerger 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, 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.

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 usingVertical 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 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, 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.