by Hervé Tanguy,
Founder and CEO of Ykems
Published in La Jaune et La Rouge, Ecole Polytechnique, Oct. 2013
Vertical Integration meets two kinds of objectives: improved operational efficiency and a stronger competitive position. These goals can also be reached by other means. Although there is no ready-made recipe for determining the right strategies, knowledge of fundamental concepts and case studies can inform decision makers.
— Outsource or not certain services? Acquire firms positioned upstream or downstream relative to core business? While the question of vertical integration constantly comes up, analyzing the expected results of such movements is by far the least intuitive and, therefore, less controlled by the management while making strategic decisions. This is not surprising as the subject is delicate, related to a specific technological context and to the structure of the market. However, modern textbooks on Industrial Organization provide a framework for fundamental analysis to clarify vertical integration issues and objectives, distinguishing two perspectives.
The first one is based on « organizational » efficiency: is it better to acquire the means of production and distribution than to outsource them and write contracts? The second focuses on the « competitive » issues of such strategies and the evolution of players’ market power in bilateral oligopolies when one of them intends to integrate vertically.
The question of « vertical » integration is fundamental to corporate strategy. Should steelmakers integrate coal and iron ore mining sectors? Should glass manufacturing develop soda ash production? Should producers of phosphate ore invest in phosphoric acid units? Cement companies in ready-to-use concrete? Aluminium-mining companies in alumina production? And if so, at which stages of their development? To what extent?
The first approach weighs the benefits of coordination between two integrated entities against the loss of direct incentives for the management to improve / preserve the competitiveness of their activities as the threat to suffer from direct competition disappears. Synergies in production / logistic costs and in investment along the value chain sometimes dictate choices, like allowing the elimination of some production stages (e.g., cooling of ingots before transport, then re-warming for rolling or alloys manufacturing).
> Allow the reduction of production stages.
Placing ourselves on the side of the buyer, we automatically think of the difficulties involved in drawing up contracts that will ensure the delivery of the right product at the right time to the right place, which is an increasingly acute problem to overcome when orders are frequent and future demand is uncertain. The situation calls for putting planning activities at the core of an integrated entity to ease the management of the variability of the ordered volumes, product quality, etc. In case of conflicts, a hierarchical arbitration will then be necessary but anticipating this action calls for learning how to mutually adjust to uncertainties. On the other hand, the integrated supplier, assured of outlets, could lose the drive to innovate compared to non-integrated ones for whom it is vital. As the English philosopher Samuel Johnson puts it : « When a man knows he is to be hanged in a fortnight, it concentrates his mind wonderfully. »
Long-term contracts or vertical integration ?
When there is a large gap with the corporate culture and know-how of a candidate for integration, the solution generally lies in concluding long-term contracts with a small number of suppliers. Reducing the number of suppliers can be seen as giving an economic rent to the lucky winners. But the contract guarantee encourages them to make medium-to-long-term investments and establish good relations that will eventually benefit to the customer. However, there is an implicit bet in this solution; eg the absence of market penetration of better performing substitute materials by the time the contract ends.
Oliver Williamson, an American economist, is the uncontested inspiration behind theories concerning organizational efficiency. He introduced the transaction costs concept (Williamson O., 1975, «Markets and Hierarchies: Analysis and Antitrust implications», Free Press, New York)
The aluminum example
To conclude with organizational efficiency, if a single characteristic of the relationship that governs the choice of vertical integration should be kept in mind, it would be, undoubtedly, the explicit level of investment that suppliers and customers agree upon to create value. Take, for example, the aluminum sector. Raw aluminum is produced from alumina, the result of bauxite refining, then converted into rolls and sheets. The range of major purchasers of alloys is extensive: from aviation to automobile industries including the packaging industry (beverage cans). The metal is also easily recyclable.
In the beginning, the sector was vertically integrated from bauxite to primary aluminium and even downstream (the purchase of American Can by Pechiney). Then, in a simplified way, it splitted up into three parts with (i) the entry of upstream production activities – raw bauxite-alumina-aluminum – into the portfolio of mining groups (BHP, Rio Tinto), (ii) industrial transformation of aluminium (foundry, extrusion, lamination – Constellium) and, finally, (iii) the manufacture of end-products.
As Bauxite travels badly and as alumina plants are dedicated to the characteristics of raw materials, refining takes place near mines. Bauxite and Alumina production has always been integrated. Considering the cost of a refinery, an investor building near a mine cannot be satisfied with a supplier contract – be it long term – that would expose him to an enormous risk of renegotiation of its contract once the specific investment is “sunk”. In any case, contracts are incomplete and very costly to validate legally. Anticipating inevitable re-negotiations, incomplete contracts automatically induce lower investment in specific assets (Hart & Moore, 1988) thereby making vertical integration the only choice.
> Vertical Integration is a way to preserve, even more, to increase market clout and ensure the implementation of specific investments.
REASONS FOR NOT INTEGRATING VERTICALLY (aluminium example, continued)
Because Alumina can easily be transported and as its electrolysis (leading to raw aluminum) is energy-intensive, the location of aluminum plants in areas where the cost of energy is low is preferable (Rio Tinto, Alcan Canada, Aluminium Bahrain). Of course, as processing is continuous, the risk of supply interruptions could make a case for vertical integration. But the “financialisation” of the aluminum market has opened the door to more “complete” alumina contracts with a price indexed to aluminum, thereby offering an alternative to vertical integration.
Downstream, more than simplifying contractual relationships linked to the indexation of input costs and output prices on aluminum price, the relative weakness of economies of scale, the interest in being near customers and aluminum recycling sources, and the need to manage the competition by offering substitutes for aluminum have brought about a totally other logic concerning the secondary production of aluminum, thereby facilitating split ups (Constellium, a spinoff of Rio Tinto Alcan).
From a competition point of view, vertical integration can be seen as a way to safeguard and also increase market clout, particularly in bilateral oligopolies (high degree of concentration upstream and downstream).
Consequently, integration could be treated as a problem of entry into a new market with all the relevant classic strategic analyses except that, according to the example of upstream integration, the company becomes both a supplier and competitor for customers… unless it chooses to integrate so massively that it totally abandons the intermediate market and starts to supply the customers of its old customers. Partial and selective upstream and downstream integration is frequent as evidenced in the following examples: downstream integration of cement producers in ready-mixed concrete or of wine growers in the production and sale of Champagne, upstream integration of steelmakers in coking coal mines.
> Increasing negotiating power to the point of threatening supplier profitability.
Cement and concrete
Cement industry is highly capitalistic and, as cement logistic costs are very high compared to its price, production facilities are concentrated in specific geographic zones (allowing them to minimize the plant-to-market logistic costs). Ready-mixed concrete (RMX) represents an important outlet for cement, notably in developed countries, and competition is much more intense than on the cement market (weaker barriers to entry on limited geographic markets due to very high transportation costs). However, certain players with alternative supply sources (imports, substitution hydraulic binders) or those having privileged access to aggregates quarries can improve their relative competitiveness, develop through acquisitions and increase their bargaining power to the point of threatening the profitability of their cement suppliers (« power buyers »).
From time to time, certain RMX supplier groups become large enough to favor new entrants in cement production (indeed to integrate themselves in cement production), thereby threatening the profitability of the incumbent cement manufacturers: demand being price inelastic, any overcapacity risks leading to a price war that would ruin the entire industry.
For the threatened cement company, attempting to acquire such a power buyer is not necessarily a good move: besides setting a “bad example” for other RMX candidates, the beneficiary of the deal would have access to financial resources allowing it to repeat its success story on a greater scale. But for a cement player, massively integrating in RMX as a measure of prevention is not even a solution considering the easy-to-overcome entry barriers in this sector and its business logic that is radically different from that of the cement industry. On the other hand, to be present in RMX in a limited, selective manner will be of real interest for the cement company: slowing the emergence and growth of power buyers competing with them thanks to its “Trojan Horse” in the sector and lowering the ambitions of future potential rivals.
> Secure supply and increase competitiveness in end markets.
Increase competitiveness via upstream integration
The following case study is a good example of this strategy. The two major raw materials of the iron and steel industry are iron ore and coking coal. Both upstream mining sectors, in the hands of powerful groups, are more concentrated than the steel industry. While its competitors mainly source themselves on the market (and have a very low integration level in coal mining compared to their needs), in the past ten years Mittal has pursued an upstream integration strategy in its coking coal mines, securing a significant proportion of its needs.
Thanks to its «upstream» integration strategy, the Mittal Group could be interested in backing high market prices for coal when negotiating with the major suppliers. It would, therefore, become relatively more competitive than its main non-integrated competitors on end markets, its average production costs having been reduced by its partial upstream integration: this would thereby give it the means to expand business to the detriment of the other steel producers.
Transforming the competitive game
Although demonstrating different characteristics, the Champagne industry has been the theater of similar movements. Winegrowers – once the exclusive suppliers of grapes to trading houses owning name brands – have progressively integrated downstream, to develop and sell Champagne (through direct sales or through co-operatives such as Nicolas Feuillatte). Benefitting from the reputation of the generic label of origin “Champagne”, they succeeded in gaining market shares against wine merchants on the French market (and, in a lesser extent, on export markets as well), although their own private brands were initially unknown. De facto, they managed to improve their price-bargaining power vs wine merchants because of the scarcity of grapes (removed from the market as the wine growers have vertically integrated in direct sales).
THE CHAMPAGNE MARKET
Today, wine merchants do not sell «more than» 68% of total Champagne volumes across all markets although they are the owners of the most famous Champagne brands. The wine merchants positioned in weak brand name sectors find themselves in direct competition with winegrowers and co-operatives producing their own Champagne. The 32% of remaining consignments are divided between winegrowers (23.5%) and co-operatives (8,5%) selling under their own name.
Simultaneously, they also succeeded in improving their competitiveness on the final market, benefitting from the higher prices of grape on intermediary market. Upstream integration being statutorily difficult for wine merchants (SAFER preemption in vineyard transactions), only major brands were able to score, by positioning themselves firmly in the global market, selling a distinctive, big-ticket item and, thereby, enhancing their private brand awareness capital (see Gaucher, Giraud &Tanguy, 2005) .
Be the first to move
Vertical integration strategies are clearly the result of intense upstream and downstream competition and can be exploited for the benefit of the first mover. When one is not an initiator of a trend, there is often no other choice than to follow the same strategy (“bandwagon effect”). Sectors that were vertically separated initially will find themselves entirely integrated within a few years because of the competitors’ growing fear of being the odd man out, the one no longer
having a secure outlet and, at the same time, seeing customers threatened by the predatory strategies of now downstream- integrated competitors. This ‘verticalization’ is often the result of a double movement of downstream integration of certain powerful groups and the upstream integration of major customers wanting to safeguard their supplies in a shrinking market.
Give priority to value creation
Compared to other situations concerning competitive strategy, there isn’t any definitive standard methodology or any convenient recipe for vertical integrations and split-ups. Having knowledge of some basic economic concepts illustrating concrete examples is a good starting point to help decision-makers facing such challenges. Whether it is to improve transaction costs or to increase market clout, the value creation target must be clarified at the start before being challenged according to the concerned sector characteristics.