Vertical Integration - Emerging trends and Challenges

1. Introduction

Vertical integration is the degree to which a firm owns its upstream

suppliers and its downstream buyers. Contrary to horizontal integration,

which is a consolidation of many firms that handle the same part of the

production process, vertical integration is typified by one firm engaged in

different parts of production (e.g. growing raw materials, manufacturing,

transporting, marketing, and/or retailing).

There are three varieties: backward (upstream) vertical integration,

forward (downstream) vertical integration, and balanced (both upstream

and downstream) vertical integration.

A company exhibits backward vertical integration when it controls

subsidiaries that produce some of the inputs used in the production of its

products. For example, an automobile company may own a tire company, a

glass company, and a metal company. Control of these three subsidiaries

is intended to create a stable supply of inputs and ensure a consistent

quality in their final product.

A company tends toward forward vertical integration when it controls

distribution centres and retailers where its products are sold.

Balanced vertical integration means a firm controls all of these

components, from raw materials to final delivery.

The three varieties noted are only abstractions; actual firms employ a

wide variety of subtle variations. Suppliers are often contractors, not

legally owned subsidiaries. Still, a client may effectively control a supplier

if their contract solely assures the supplier's profitability.

This paper discusses about emerging trends in vertical integration in post

recession era and probable challenges there upon.

2. In house Vs Outsource:

Major considerations for the expansion though Vertical Integration would be the In

house versus Outsource analysis -to assess what part of supply chain a firm

should gain control and make it an in-house versus contract out to a third party or

outsource .

3. Drivers for the decision:

There are 5 primary assessments which need to be conducted across the supply

chain- the key drivers for In house Vs outsource decision

• Strategic Importance:

The product/service or a business process contributing towards

uniqueness or intellectual property and gaining competitive advantage

due to differentiation cannot be outsourced. Factors impacting short and/

or medium term cost advantage may or may not hold true in longer term.

Such assessment is required while evaluating the options.

• Operational Competence:

If the product category / manufacturing technology under assessment is

medium to highly sensitive towards quality requirements and requires

medium to high technical / resource support the firm may chose to make it

an In-house development or control.

• Supply Depth and Competitiveness:

Availability of contract manufacturing options and intensity of industry

competition is a relevant factor. Level of product / manufacturing

technology differentiation and Level of cost competitiveness relative to

firm also may impact the In-house or outsource decision.

• Potential Bargaining Leverage:

Bargaining power of suppliers and / or distributors may impact the firm’s

decision regarding the vertical integration. Bargaining leverage the firm

enjoys in its supply chain is a key assessment driver for make or to buy

decision.

• Scale benefit from specialization:

Low costs of production (cost per unit or the average cost) can only be

achieved if a firm is producing an output level that constitutes a

substantial portion of the total available market. Inbound and outbound

logistics- M & A may not be a better choice always. Owning a logistics

division for a seasonal and limited Usage may not be an intelligent option

rather than outsourcing it. A logistics firm handling operations for various

firms may attain cost benefits due to economies of scale and

specialization and may pass on that profitability to the outsourcing firms.

4. Pre Recession era
Vertical integration is a century old strategy pioneered during the industrial

revolution. The old style of vertical integration usually crossed multiple industries.

With vertical integration, an organization controls the supply of raw materials and

the delivery of its products. In other words, it has ‘complete control’ over its supply

chain. More inclined towards In-house development.

Later the trend moved towards outsourcing, core competencies and gaining cost

reduction due to specialization. Outsourcing has been prospering since the 90s for

various reasons such as cost reduction, focus on core competencies, Risk mitigation

and a long list of others.

5. Post Recession era

But if we have been following the news lately, it is hard to overlook the shift to

‘vertical integration’ by a number of leading companies such as Oracle, Apple,

Arcelor Mittal, GM, Boeing, Pepsi, Tata to name a few. Oracle has been on a

spending spree over the last few years by acquiring just about any maker of

software, computers, and computer components. The intent is to sell ‘complete

systems’ made of chips, computers, storage devices and software from Oracle.

Apple which exited the semiconductor business recently shifted its strategy by

silently grabbing small semiconductors suppliers so it can develop its own chips to

meet its popular new devices.

General Motors, despite its struggle, is also moving towards a lean vertical

integration model by grabbing a number of struggling suppliers (e.g. Delphi) and

purchasing factories. The trend towards vertical integration is driven by many

reasons such as more control over raw materials (e.g. Arcelor), more control over
parts supply (GM, Boeing), more control over beverage distribution (Pepsi), and

strategic differentiation (Oracle, apple).

Major contribution to this phenomenal shift is sick units being available at through

away prices and evolution of few sustained market leaders in post recession era.

6. Emerging challenges

Post M&A Integration issues:

This new style vertical integration (M & A) will make supply chain much more

complex to manage and control. Bureaucratic, cultural and organizational issues

have long plagued the supply chains which are often masked by the magnitude of

the profits in some industries such as oil &natural gas.

Regardless of the degree of vertical integration, supply chains are unlikely to

disappear or become easier to manage or control. With multiple acquisitions,

organizations end up having multiple supply chains each as complex as the other.

The resulting supply chain is slow and bogged by process inefficiencies and limited

internal collaboration.

Conflicts of Interests:

Organizations comprising of multiple business units adopting Vertical integration

within one or more of their business units could face challenges in addressing

conflicts of interest arising due to multi point competition in related and / or

unrelated industries.

Challenges due to Dynamic economies:

Further, countries such as India and China present unique challenges in that their

fast growing economies fuel significant changes over short to medium term. This

requires dynamic and agile supply chain systems which pose significant challenges

to such a vertical integration.

Exit barriers:

Another concern is whether the anticipated economic gains will materialize. Before

expanding the scope of the firm through vertical integration, management should

be sure that the imagined benefits are real. Many blunders have been made by

firms that broadened their scope to achieve benefits that did not exist. If the

barriers of exit are significant; a firm may be forced to continue to hold the

acquisitions of the vertical integration, as the costs of leaving may be higher than

those incurred if they continue with the holdings which may not be a desirable

outcome.

7. Conclusion

Changing dynamics of economic health Vis- a -Vis evolving requirements

of business post recession have fuelled significant changes in trends of

vertical integration. While vertical integration is core to business models

servicing growth especially in economies such as India. This paper made

an attempt at highlighting key drivers which are critical for defining the

future trend of vertical integration. Both strategic and operational

challenges as highlighted in the paper are likely to influence the emerging

trends for such integration.

It is hence pertinent that business houses are cognizant of these drivers

and suitable risk mitigation steps need to be put in place in order to

design a sustainable vertical integration model in line with their growth

business needs and addressing risks arising in short to medium term.

8. References:

• Mansfield, Edwin. Essential Microeconomics: Principles, Cases, Problems.

• Johnson G, Scholes K and Whittington R, (2006), "Exploring Corporate Strategy",

Prentice Hall International

• Bain, Joe S. Barriers to New Competition: Their Character and Consequences in

Manufacturing Industries

• Martin K. Perry. "Vertical Integration: Determinants and Effects". Chapter 4 in:

Handbook of Industrial Organization. North Holland, 1988.

• Joseph R. Conlin. "The American Past: A Survey of American History". Chapter 27

page 457 under "VERTICAL INTEGRATION". Thompson Wadsworth. Belmont, CA,

2007.

• The Re-rise of Vertical Integration: Mega or Dead Supply Chains? By Farid

Harche - Senior consultant Wipro BAS

Appendix 1: Acquisition of Shantha Biotechnics by Sanofi

Pasteur

Paris, France – July 27, 2009 - Sanofi-aventis (EURONEXT: SAN and NYSE: SNY)

and Mérieux Alliance announced the signature of a strategic agreement for the
acquisition by Sanofi Pasteur of Mérieux Alliance’s French subsidiary ShanH,

which owns a majority stake in vaccine company Shantha Biotechnics based in

Hyderabad, India. A new joint committee will be chaired by Alain Mérieux on

vaccine strategy for the Emerging Markets.

Under the terms of the agreement, Sanofi Pasteur, the vaccines division of the

Sanofi-aventis Group, will support Shantha’s ongoing development as a platform to

address the need for high quality affordable vaccination in international markets. Dr

Varaprasad Reddy, the founder of Shantha Biotechnics, will continue to lead the

company as Managing Director.

Shantha Biotechnics was created in 1993 by Dr. Varaprasad Reddy and is

based in Hyderabad, India. Shantha develops, manufactures and markets several

important vaccines. Shantha works with supranational organizations like UNICEF

and WHO supply major international markets including Asia-Pacific, Africa and Latin

America.

Sanofi-aventis, a leading global pharmaceutical company, offers the broadest

range of vaccines protecting against 20 infectious diseases. Every day, the

company invests more than EUR 1 million in R & D. Sanofi-aventis has a workforce

of 105,000 employees in 110 countries and its net sales were of €29.3 billion in

2009. Sanofi-aventis is listed in Paris (EURONEXT: SAN) and in New York (NYSE:

SNY).

Mérieux Alliance, the family holding company of Alain Mérieux comprises five

companies dedicated to public health that span the full range of healthcare:

prevention, diagnosis, prognosis, treatment and clinical follow-up.

Strategy of Acquisition
 For Sanofi Pasteur: Sanofi Pasteur strengthens vaccines position in India

through the control of Shantha Biotechnics via Mérieux Alliance. Shantha shall

operate as an R & D wing extension and new distribution channel for Sanofi in

emerging markets

 For Shantha: This evolution was rolled out respecting Shantha’s philosophy to

provide developing countries with international quality level products at an

accessible price. Shantha’s future development necessitates of bringing a state-of-

the-art vaccine manufacturing facility gets a support from a major international

vaccine company

 Alain Mérieux to chair a new Vaccine Strategic Committee of Sanofi Pasteur

for Emerging Markets

Context of Acquisition

 Mérieux Alliance acquired the majority shareholding in the Shantha

Biotechnics Limited in November, 2006. ( Mérieux Alliance acquired 80% of the

stake)

 Death of Alliance CEO’s son who was supposed to take over the charge of

Shantha meant the firm lacked managerial guidance and effort for nearly 3 years

 In 2009, Sanofi-aventis and Mérieux Alliance signed a strategic agreement for

the acquisition by Sanofi Pasteur of Shantha Biotechnics

 Acquisition particularly focused on successful launch of a pentavalent

pediatric vaccine as well as a Cholera vaccine. Its main activity being

strengthening a portfolio of new products which are in development: Rotavirus

vaccine, Conjugated Typhoid vaccine, and HPV vaccine

Present situation

 Employees have identified more with Mr. Varaprasad than the firm Shantha.

Lack of ‘sense of connect’ with the firm and the acquired brand contributed to

many employees leaving the firm- Attrition rate rose from 23 % to 73%

 Within a year of acquisition Sanofi Aventis-owned Shantha Biotech is recalling

several lots of its 24 million five-in-one vaccines globally after WHO found it

unsuitable for use and raised concerns over its safety. This is estimated to be

causing a loss of around $72 million

 WHO and UNICEF have asked Hyderabad-based Shantha Biotech to

determine the root cause of the problem and prepare a corrective action plan

within two months, failing which the company's vaccines will be disqualified from

supply to the agency

 Besides losses from the recall, if WHO disqualifies Shan5, the Indian company

could lose a $340-million UNICEF contract to supply Shan5 for 2010-12

 This is a setback to Sanofi Aventis, which bought 80% in Shantha in July

2009, valuing the company at € 550 million. From past 3 to 4 years Shantha

Biotechnics is not in a position to launch a single vaccination

 Lot of money is being pumped into Shantha by sanofi to get the situation up

and running and correcting the organizational disparities both in culture and

technology

Epilogue

In lieu of above discussion it may be concluded that all M& A need not head towards

a desired result.
Bureaucratic, cultural and organizational issues arising from the M & A have to be

taken care of.

Management should be sure that the imagined benefits are real by performing an

extensive due diligence.

Appendix 2: Merger of Axis bank and Enam i-banking arm

Axis Bank on Nov 17, 2010 announced acquisition of investment banking and other

businesses of Enam Securities for Rs 2,067 crore, a move that will allow the private

sector lender expand its footprint in i-banking and retail broking space similar to its

rivals HDFC and ICICI banks.

Under the deal, Axis Bank's first inorganic growth foray, Enam's shareholders --

Vallabh Bhansali, Manish Chokhani, Jagdish Master and Nimesh Shah -- will get 5.7

shares of Axis Bank for every one share held which will constitute about 3.3 per

cent of the lender's equity base on enlarged capital. Bhansali will also be inducted

on to the Board of Axis Bank as an independent Director while Chokhani will be the

Managing Director and CEO of the newly formed entity created by the merger.

Axis Bank was the first of the new private banks to have begun operations in

1994, after the Government of India allowed new private banks to be established.

The Bank was promoted jointly by the Administrator of the specified undertaking of

the Unit Trust of India (UTI - I), Life Insurance Corporation of India (LIC) and General

Insurance Corporation of India (GIC) and other four PSU insurance companies, i.e.

National Insurance Company Ltd., The New India Assurance Company Ltd., The

Oriental Insurance Company Ltd. and United India Insurance Company Ltd.
The Bank today is capitalized to the extent of Rs. 408.84 crores with the public

holding (other than promoters and GDRs) at 53.81%. The Bank has a very wide

network of more than 1095 branches and has one of the largest ATM networks in

the country.

ENAM was founded in 1984 to provide knowledge-driven financial services at a

time when the Indian economy was being redefined by market-oriented reforms.

The founders - Manek Bhanshali, Nemish Shah, Vallabh Bhanshali and Jagdish

Master - were referred to as the Formidable Four of Dalal Street.

Being privately owned by professionals contributes to an exceptionally high level of

commitment to excellence in client service. Almost all the key decision makers who

have joined Enam over the last 20 years are still with it. Enam’s partnership

approach is unique in the Indian context.

Strategy of the Axis Bank

Axis Bank will use the ‘Enam brand ‘ , one of the strongest among the pure-play

domestic financial majors, for two years and there will be a non- compete

agreement on the merged business for the next five years.

The transaction has the potential to create a financial services powerhouse in the

country and it combines the investment banking and equities strength of Enam

securities and the dominant debt market and commercial banking operations of

Axis Bank.

Perspective of Enam
India is going to see so much capital investments that the landscape is going to

change dramatically.

There would have been several handicaps for Enam to grow individually since as

business grows there would have been a need for significantly large sums of capital.

Enam saw this opportunity to move to the next level.

Market situation

 The M & A deals in India bring in the fees in the range of 1% to 4% of the value

of the deal and the market is worth about $800 million (About Rs 3500 crores) in

terms of fees, annually

 On the other hand, Issuance of shares through IPOs, FPO and QIP- bring in fees in

the range of 0.5% to 4% of the deal value

 Axis bank has been growing at about 20-30% annually without strong

investment banking wing. Now with strong M& A advisory team and equity

issuance issue team under its command and a strong balance sheet to back the

deal -will probably make Axis Bank grow at a much faster pace

 It is clear attempt by Shikha Sharma( Axis bank MD & CEO) to create and

integrated financial services firm that will bring banking and investment

banking under one roof

 The deal comes at a time when the government is planning to sell equity in

about 60 state run firms. Although Government deals do not bring in much

money, but that takes the merchant banker higher up the M & A league table
 It is well known fact that being in the top deck in the league table brings in the

clients from private sector that pay for the service

Epilogue

The combination of capability & capacity of Axis with the talent & experience of

Enam in the equities market makes it a strong merger. Through such acquisitions,

Axis Bank targets to become a one-stop financial service provider," said Gaurang

Shah, assistant vice-president of Geojit BNP Paribas Financial Services.

Enam, which is credited for pioneering equity research in the country, enjoys much

of its strong reputation for its corporate business. The guarantee that the

considerable goodwill enjoyed by Enam would get transferred to Axis Bank is still a

question of debate and to be proven by time.