When Two Companies Love Each Other…

Posted on by Travis Lane

It’s been an interesting quarter in the business world. I decided to write about mergers and acquisitions fairly soon after my last lesson, and the universe granted my wish and provided a whole host of relevant pairings to talk about, running the gamut from monumental (AT&T acquiring Time Warner) to mundane (high-end computer peripheral company Razer purchased THX – you know, the “Deep Note” people you remember only when you go to the movie theatre). In fact, in preparation for this post, I gathered half a dozen interesting M&A stories from this quarter alone. Maybe it’s a hot quarter for it, or maybe I’m falling prey to the frequency illusion. Either way, here’s some of what’s going on around us:

Mergers and acquisitions occupy their very own segment of the business world, not entirely separate and distinct from the more typical business topics of finance, accounting, strategy, management, and so forth, but not entirely part of them either. While it has tie-ins – companies wouldn’t be interested in going through M&A effort if it didn’t matter financially – it has its own set of benefits and opportunities, as well as unique risks and pitfalls.

In talking about this, I’m stepping into a dark and scary place, so I’m going to keep it as simple and high-level as possible, and provide some threads for you to pull on if you want to sink deeper.

To paint with a broad brush, the two major types of M&A strategies are horizontal integration and vertical integration. In today’s call, you probably heard the terms “horizontal” and “vertical” a number of times. Let’s quickly talk about each one.

Horizontal Integration

A horizontal merger is when two businesses do the same thing, and move forward doing that same thing together. This happens in the auto industry all the time. We build cars, you build cars, let’s see if we can work together to build more or better cars.

The financial upsides of horizontal integration are typically one or more of the following:

  • Economies of Scale: since we’re building more product, we can utilize our resources better.
  • Increased Market Access: for instance, if Company A was rocking it in North America, Company B in Europe, the new company can expand the combined global footprint.
  • Increasing Buying Power: instead of getting the bulk discount for 50,000 parts, we can negotiate a new discount for 100,000 parts.
  • Increased Market Influence: by owning more of the market, a company can more readily set prices and expectations; this can be a very powerful tool, so much so that regulatory agencies have the ability to block mergers under antitrust law if they would effectively kill competition in the marketplace and create a monopoly.

As we’ve talked before, generally, doing more business is good. Being more efficient is good. Having more influence is good. All of these things are possible positives from a horizontal merger. However, there are some complexities, both operationally and intangibly. Some of the risks or difficulties in executing a successful horizontal merger may be:

  • Cultural mismatch preventing the realization of operational efficiencies. Too much time can be spent fighting two opposing sets of “We’ve always done it this way” to actually integrate the two separate companies into a stronger whole. Mergers are also tough, and can impact morale, resulting in turnover, disengagement, and other problems that are difficult or impossible to put on paper.
  • Complexity leading to growth in overhead, rather than reduction. Ideally, going horizontal lets a company manage more business with the tools it already has, but the differences between two formerly distinct companies may be too complex to rectify into a more efficient structure.
  • Incongruent dependencies prevent cost efficiencies. For example, Company A can only obtain parts from Company X, while Company B can only obtain parts from Company Y. If their supply or partner bases are overly specific or constrained, it may keep the operations functionally separate after the merger intended to combine them.

Overall, a horizontal merger aims to do more of the stuff we’re already doing well. In the list above, Bass Pro Shops + Cabela’s and TD Ameritrade + Scottrade are clearly horizontal mergers, aimed at gaining market share, market access, and growing the underlying business by doing so.

Vertical Integration

With vertical integration, a company will buy another company at a different layer of the supply chain or value chain. In the automotive world, if horizontal is like Volkswagen buying Audi, vertical is like Volkswagen buying Car Trim GmbH, an interiors supplier and specialist company.

The stated benefits of a vertical merger are one or more of the following:

  • Guaranteed supply base: if you own the supplier, you have full visibility into their operations and priorities, and can control their output at a much finer level. This can let you dig into the details of processes that are difficult to obtain or entirely out of sight otherwise.
  • Capture margin: simply put, if you’re paying a supplier a 10% profit margin on their parts, when you own the company, you can drive those costs down internally or capture that margin if you continue to supply to other companies.
  • Indirect market control: if the supplier also works with your competitors, you can exert more control over pricing and pacing in the market by owning a key piece of the supply chain.

But nothing is ever perfect, or easy, or perfectly easy. Some of the risks and downsides of a vertical merger are:

  • Lack of knowledge or experience: familiarity with a supplier doesn’t necessarily translate into mastery of their business. With horizontal mergers, you’re already used to executing that business. Vertical mergers may force you to operate outside of your core competencies, with associated learning curve and costs.
  • Rigidity: one of the benefits of having an outside supply base is that you can be fluid with your supply chain choices. If another company is cheaper, or your current supplier sucks, or you can do the job better internally, you can switch over with comparatively less pain. If you’ve purchased a major element of your supply chain, you’ve made an expensive commitment to insourcing, leaving you less flexible to respond to market changes.
  • Difficult integration: as with horizontal mergers, or any merger for that matter, realizing the purported gains can be very tough, for a wide swath of reasons.

With a vertical merger, we want to go deeper into our business, not wider. AT&T + Time Warner is an example of a vertical merger – AT&T distributes content, Time Warner creates it. Verizon + Yahoo would be similar. Dick’s Sporting Goods + Golfsmith is another example, even if the bankruptcy element makes it a bit different.

Further Reading

The further this series of mini-lessons goes, the more complex it seems to get. My goal is always simplicity, and mergers and acquisitions are just one of those topics that aren’t simple any way you slice it. In spite of the title, while some mergers are well-received and mutually supported, there’s a whole genre of them that is bitter and painful. Often, major players in one or both companies disagree on the benefits, and it can be a nasty process to execute the merger or acquisition itself, much less successfully realize the stated gains. Nonetheless, I hope this has been a good first pass to get comfortable with some of the common terms thrown around in that realm and an understanding of what we’re trying to accomplish when we pursue M&A activity.

If you want to learn more, Investopedia has some really good articles that could easily lead to a 10+ tab session of Chrome if you want to dig a little deeper into this world: