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Why vertical integration is reshaping the U.S. economy

vertical integration

Evidence of a fundamental shift in market dynamics is on display daily in the business press.

CVS announced its intention to buy Aetna. Cigna buys Express Scripts. Now, with Amazon’s acquisition of PillPack, the industry is under siege.

In telecommunications and media, AT&T (cell and DirectTV) is attempting to acquire Time Warner (cable and content provider). It’s as if the construct of our economy is being transformed practically overnight, and in all of these cases, vertical integration is the tip of the spear.

Vistage members should take notice. According to Morgan Stanley, 2018’s No. 1 merger-and-acquisition trend is non-technology companies buying technology companies and vice versa.[i]  These new business combinations provide unique opportunities for companies (big and small) to re-frame how they deliver value to the market including participating in new service offerings.

Such deals were commonplace in the ’80s, when large manufacturing concerns made attempts to control cycle time and costs upstream and downstream. Today buyers face a new reality. After a decade of rollups, they have run out of competitors to buy. They have re-calibrated and are looking to consolidate the value chain.

Downstream suppliers will have to pivot to remain relevant. To succeed in this new world order of vertical integration, Vistage members should:

1. Provide end-to-end solutions.

As industries consolidate, customer behavior changes. Large companies in mature industries like aerospace and food distribution have deeply entrenched professional procurement organizations. Such companies are consolidating their suppliers and are looking to utilize fewer vendors who are more capable. Today’s contemporary supplier must comply with onerous requirements from standards on cybersecurity to ensuring use of sustainable methods. Some customers are even auditing their suppliers’ financial records to ensure they do not have too much concentration in a few customers.

Vistage Decision factors: HR 2018 report
Related: Economic considerations for H2 2018

Business-to-consumer (B2C) customers have similar expectations for a wide swath of products to be delivered the next day at bargain basement prices. Providers will need to have expansive capabilities to satisfy these needs. Suppliers should focus on a narrow number of markets but provide complete solutions within them.

2. Identify the benefits of scale.

In every industry, savings through overhead absorption or volume discounts are achieved at different rates. That is, economies of scale are realized differently in a $50 million restaurant chain than a $10 million accounting firm. Every company should conduct an analysis to calculate how volume impacts profitability.

One of our Vistage-member clients recently completed an acquisition outside its core operating area. They did not realize the expected efficiencies, because some staff they assumed to be redundant could not be eliminated. Smart operators do the math and know at what volume synergies are likely to be achieved.

3. Conduct a value chain analysis.

Today, contemporary companies must offer the optimal suite of services. Offer too few and large customers won’t value you; offer too many and you could create value-destroying complexity. Every time a supplier includes a feature or service in its bundle, there is an opportunity cost– those dollars cannot be invested elsewhere. Vendors who provide “just good enough” often have a cost advantage.

Conducting a value chain analysis allows suppliers to pinpoint the specific services customers value most. They should start by quantifying the relative value of each component of their product or service bundle. A hypothetical example: A Starbucks cup and cardboard sleeve may be worth 20 cents, the coffee 90 cents, and the experience $1.50. Experience is central to Starbucks’ value proposition, and if the company wanted to serve other parts of the value chain, it would seek to augment the element customers value most: experience.

4. Consider vertical integration for yourself.

Our clients who buy costly raw materials are buying the factories that furnish them. We are seeing this with small companies and even service companies. Given the state of hyper-competition, vertical integration provides control and points of margin critical in maintaining competitive advantage and promoting investment in hiring, technology, etc. Vertically integrated companies are more immune to swings in the economy and are therefore more valuable in a liquidity event.

5. Form alliances.

Achieving vertical integration does not require common ownership. Companies are leveraging alliances and various business combinations to offer the stability or cost savings of integration without risk. Collaboration is a powerful method for expanding reach. Entire business models such as Amazon and eBay are built on partnerships with other suppliers.

A final word of caution: A critical pitfall to avoid is the appearance that a vertically integrated company could favor internal customers or shut out others. If a customer were to buy a supplier, competing suppliers may fear they won’t be treated fairly. Ensure clear communication about your interactions after such a transaction.

Vertical integration is a powerful mechanism for creating value. All companies, regardless of size or industry, should be paying attention to fundamental shifts and the impact on their industries.

[i] 5 M&A Trends Investors Should Watch in 2018, Morgan Stanley

Read more on this topic: 10 tips to transform your business

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