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The ins and outs of vertical integration

Jun 19 2017 14:10
Simon Brown

Squeezing out more revenue per unit sold is one way to increase profits. Profits will also rise if there is increased demand for a company’s product or service. But focusing on the former, one very effective way to increase profits, or margins, is vertical integration – most companies’ dream.

While the notion seems simple, getting it right is hard. The concept is that you have a process that requires supply inputs from third parties that you pay and these third parties make a profit on supplying you. But what if you could provide that input yourself and you’d make the profit on whatever it may be?

Take the recent purchase by Steinhoff of US bedding producer Sherwood as an example. Last year it also acquired Mattress Firm, which has some 3 500 outlets in the US. But Steinhoff must still buy the beds from a third-party manufacturer, which makes a profit on those beds.

So why not buy a bed manufacturer and earn on both the manufacturing of the bed and the ultimate sale?

This is pretty much what it did with Conforama and this was positive in two ways: Conforama  manufactures it's beds in Eastern Europe, which is cheaper, and sells them in France where it gets better prices.

This process could be taken further - since  one  of the major inputs to furniture is wood, why not also buy fostery operation to supply your manufacturer with the required raw material?

The other good local example of this is Famous Brands*, which now supplies its franchise operations with everything from serviettes to tomato paste. Back in the day the company only earned revenue from franchise fees, but now it also earns an income from the manufacturing as well as distribution of its various products to the many brands it has.

This means that it now has three distinct areas of profit rather than just the franchise operation.

Another recent example is Comair, which has started providing its own food service rather than outsourcing it. It claims this strategy allows it to save R37m annually and has allowed it to improve the quality of the meals it serves passengers.

Another potential strategy would be to provide those services or products to other companies. So, Steinhoff could sell Sherwood beds to other firms, Comair could provide catering to competitors and Famous Brands could sell serviettes to other food outlets.

Naturally, these competitors may not like the idea of buying products from a rival, but if the price and quality are right, they’d be stupid not to.

If done well – as was the case for Steinhoff and Famous Brands – vertical integration sees lower prices at the retail level and/or better margins because you make money at every turn and so can afford to lower margins down the supply chain. 

Then at the end of the day the lower prices are a competitive advantage and the company has maintained or improved margins.

There are, of course, very real risks here. If your specialty is making and selling burgers, supply logistics and manufacturing are totally different areas of expertise. So, any company rushing off to vertically integrate should ideally do so slowly.

This  is what Famous Brands did - in contrast to Steinhoff,  which just rushed in , but still managed to pull it off.

One good option is to buy an existing supplier, which will immediately add profits but as mentioned may alienate current  customers of that supplier if they are competition.
 
Another risk is one that Taste and Burger King (via Grande Parade) may have to contend with. When you first start vertical integration, the operation is small and likely loss-making, so it will affect profits negatively until critical mass is reached. If that takes too long, or is never achieved, you’re left with a loss-making operation.

Lastly, while vertical integration is the dream of most companies it is not always possible or practical. The products being supplied may have strong intellectual property (IP) or patents behind them, making it impossible unless you come up with another method.

Your supplier may be a huge global corporation. Or perhaps vertical integration is just not possible because employees are not skilled enough or it is  beyond a company's budget. But this strategy is still a great way for companies to improve profits.

*The writer owns shares in Famous Brands.

This article originally appeared in the 15 June edition of finweekBuy and download the magazine here.

steinhoff  |  profit  |  taste holdings  |  famous brands  |  comair

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