During a period of economic downturn, joining forces with another firm to create stability, strength and opportunity for growth is a solution that is viable for some companies.
Horizontal Integration or Horizontal Merger: “The union of two or more entities with similar products or services into one usually for the purpose of creating synergies.”
CFA Houston is now advising two contract-manufacturing firms in the same industry. On the surface, both companies are equals. Both companies have sales over $10mm. While competing in the same industry both companies serve different niches. Company A has equipment to perform larger and longer runs. Company B is configured to produce smaller and shorter runs. Company A has a strong group of account service personnel. Company B has a large and strong sales force. One company is further advanced than the other in modernization of equipment. Each company has excess debt capacity. Both companies have a great reputation.
Both owners are tired of slugging it out alone. During the current economic downturn, both companies are expecting sales this year to be less than last year. They can see the synergies that would be created by joining forces. A merger could eliminate numerous duplications of expense. The equipment can be better utilized to produce more work with less effort and cost. The sales and account service personnel should improve client relationships for both owners. Marginal personnel carried by all companies during a period of strong economic growth could be released to reduce overhead or moved into other areas of need. In a merger after integration, the combined entity should be more valuable than the individual components.
Here are some things you should consider about a horizontal merger:
A horizontal merger should provide Economy of Scale.
Economies of scale refer to the reductions in unit cost as the size of a facility, or scale, increases. It is the cost advantages that occur when there is expansion. In our example, there should be numerous opportunities to reduce costs. One plant could move equipment into the other with minimal disruption eliminating a rent burden. Instead of forcing work on a machine that is not as effective in its use, for example, using short run equipment to provide long run services which raises unit cost and makes the short run company less competitive, merged the combined companies are now better positioned to use the equipment more effectively.
A horizontal merger should provide Economy of Scope.
Economies of scope refer to the reduction in average total cost of production as a result of increasing the number of different goods produced. Sales and marketing should benefit the combined entity because a more complete product offering is now available. As the number of products promoted is increased, more people can be reached with each dollar spent. In our example, following the job to completion can now be more effectively handled by account service personnel freeing sales people to spend more time selling. The expansion of products to promote to customers should provide greater sales opportunities.
A merger may not require cash.
Remember a merger is about combining interests. Protecting cash can be important for the future. In our example, the combined borrowing base and the reduction of fixed costs should allow for better financing terms and a significant improvement in cash flow for the combined entity.
A merger lets both businesses realize the appreciation potential of the merged entity.
This can be a way for an owner to take chips off the table and continue to reduce risk by creating a stronger company. Additionally, a merger allows the shareholders of smaller entities to own a smaller piece of a larger pie, usually increasing their overall net worth.
A merger can be adjusted to create equality in equity.
All things considered, it is rare that two entities are perfect equals.
Therefore, a direct exchange of stock is not always the best solution. If the goal of the combination is equality of ownership 50/50, the combined company can pay the stronger company cash or debt to make up the difference. Remember in a merger, excess debt capacity and cash flow is usually created.
Bottom line, the combined entity should be leaner, larger, more profitable and better capable of surviving a prolonged downturn.
Contact CFA (713.465.4055) if you would like to look at how a Horizontal Integration could help your business.