The Pros & Cons of Vertical Integration

There are pitfalls in business combinations, but when executed properly, integration can add substantially to the bottom line
Nicholas V. Beare, Stephens Inc.
April 1, 2007
FEATURE ARTICLE | Management

Economic and industry-specific issues continue to weigh heavy on building materials companies, and many builders are asking for price reductions. To maintain prices and generate profits during a prolonged market slow-down, anxious suppliers, manufacturers and distributors are considering business integration.



Integration, as a business strategy, is nothing new. Many antitrust laws, designed at the turn of the 20th century, were created to combat business combinations that were perceived as anti-competitive. In current practice, the enforcement of these laws remains intact; however, we are seeing more horizontal transactions allowing former competitors to come together under one banner. Less stringent protocol is evidenced among vertical combinations that bring together a supplier and customer.

Whether it’s done organically or through acquisition, vertical integration is becoming a more important business strategy in the building products arena. There are, however, both pros and cons to be considered.

ADDING MORE SERVICES
PRO: As the housing market feels the squeeze, more and more builders are demanding price reductions. Instead of offering bulk price concessions, integrated building materials companies are offering more products backed by more attentive customer service.

For example, pro dealers have opened or acquired manufacturing facilities for pre-hung doors, trusses, wall panels and other prefabricated products. Further, some of these dealers are also providing installation services for windows, doors, framing, insulation and plumbing. As margins continue to come under pressure, providing a greater basket of services and products is becoming the first defense against a race to the bottom on price.

Larger builders prefer to conduct business with all-in-one suppliers that are not only price-competitive but also able to provide a broad, innovative product portfolio in addition to unique services, such as logistics management, just-in-time inventory, category and inventory management, national distribution capabilities, and superior customer service. As a possible consolidation among the country’s large national builders gathers steam, those suppliers with broad reach and service will be in the best position to serve these new mega builders.

By being able to offer these additional products and services, integrated companies are able to maintain their margins, offer more/better service to customers and potentially gain new market share.

CON: How do you successfully combine two different management teams, with seemingly different business models, into one entity? Keeping the top people from each management team may prove difficult; job inquiries sometimes follow news of business integration. To avoid key management jumping ship, the integrating companies need to establish a clear organizational structure for management of the new company and provide attractive (and intelligently structured) financial incentives.

EXTRUSION
PRO: In the window and door sector, the ability to extrude the components to assemble a product is becoming more critical to many. In general, a window manufacturer that must purchase vast quantities of raw materials is subject to fluctuations in commodity pricing. However, by combining a components producer with a fabricator, the combined company can absorb the costs (with a smaller hit to the bottom line).

The manufacturers’ extrusion capabilities were likely a factor of Andersen acquiring Silver Line Building Products and Fortune Brands acquiring Simonton Windows. By controlling the extrusion of components, integrated widow manufacturers are able to lower their raw material costs as well as better control their supply chains. In addition, integrated producers can better control quality by monitoring the process from raw materials to components to finished products.

CON: Companies can fall into the trap of expanding their repertoire without the necessary expertise. For windows, fabrication and extrusion are very different processes; success in window fabrication may not translate into success in extrusion. Whether by acquisition or facility expansion, experienced operators are required to ensure consistency and quality of lineals. Further, for an integrated manufacturer, the ability to shop for the lowest priced components is no longer an option unless extrusion and fabrication capacities are balanced to continue to allow for third party sourcing.

BETTER CONTROL OF THE SUPPLY CHAIN
PRO:
Control of the supply chain is particularly desirable for integrating companies looking to expand into new markets, rationalize distribution channels and consolidate excess capacity. The financial community evaluates mergers and acquisitions, among other things on their ability to deliver cost synergies—with the supply chain offering the potential to deliver significant cost synergies.

Control of the supply chain allows for:
• Effective procurement of goods/services.
• Timeliness of converting raw materials or components into finished goods, delivering those goods into customers’ hands, and receiving payment. 
• Protection of revenue during times of transition by ensuring customer orders are not interrupted and by enabling an organization to generate stronger top-line growth in new products, new markets and geographies.

Take, for example, Rinker Materials, a Florida-based supplier of building and construction materials, including aggregates, cement, ready-mix concrete, masonry products and building products. As an aggregates producer, the firm has vertically integrated downstream into the production of higher-value products. As a building materials company, the firm controls its supply of quality aggregates and its distribution network.

CON: Inadequate supply chain planning can have negative implications. Failed supply chain integrations result in:

  • Lower synergies than planned.
  • Delays in capturing value.
  • Supply chain disruptions that hurt sales.
  • A general increase in supply chain operating costs and efficiencies.
  • An inventory buildup that increases the cost of goods sold.
  • Less than optimal effects upon customers who could not get products.
  • A drop in product quality.
  • A significant increase in out-of-stock products.

To avoid these problems, a thorough analysis of the two companies’ supply chains should be outlined—keeping the supply chain managers active in the integration discussions. There are several questions to ponder. Are the substitute materials compatible? What is the proximity of the two companies’ physical plants? Will this delay lead-time/delivery? Do the two companies’ information technology systems, such as tracking and/or inventory, work together?

The benefits of integration extend across many areas of the building materials industry. Reduced costs, improved margins and better customer service are common facets to many of these efforts. Yet, integration should not be approached lightly. There are many pitfalls to overcome when combining two companies—an analysis of competitive issues, logistics problems, product manufacturing, and corporate cultures should be conducted.  

Ultimately, the pros appear to far outweigh the cons of business integration. When executed properly, integration produces substantial value for the end customer and likely boosts margins for the combined company. As business conditions become more volatile, we expect more transactional activity based on the potential benefits and power of integration.

Nicholas V. Beare is a managing director at Stephens Inc., a Little Rock, AR-based investment banking firm with offices around the country. Specializing in building products and technologies investment banking, Beare is based in the firm’s Dallas office where he can be reached at 214/258-2747 or at nick.beare@stephens.com.