Terms Beginning With 'v'

Vertical Integration 

What is vertical integration?

Vertical integration is an arrangement of an enterprises’ supply chain in a way that helps to fit in different stages of the production process and supply chain into its business. A company may seek to create a competitive advantage by in housing every outsourced operation. 

The intention of vertical integration is not only to gain market superiority but also for securing distribution channels and optimising cost structure. In nutshell, it is used to have control over the Industry’s Value Chain.

Management tries to show shareholders that a potential business transaction will enable a vertical integration, which will lead to synergies and better earnings. But there always remains risks of underachievement and transaction benefits may not yield the anticipated benefits. 

Companies aggressively look to grow inorganically through mergers and acquisitions. Oftentimes, a potential vertical integration is the main driver behind such transaction.  

There are two types of vertical integration: forward integration and backward integration. 

Forward integration is when a business controls retailers and distributors of its products. An example of this could be an oil and gas company with gas stations.

Backward integration is a vertical integration strategy where a business seeks to control suppliers, and therefore the inputs used in the production of goods or services. An example of backward integration could be a restaurant owning a farm to source its groceries.

What are the advantages and dis-advantages of vertical integration?

Image Source ©Kalkine Group 2020

Advantages

Cost benefits 

In the majority of the cases, the primary intent of vertical integration is to eliminate or at significantly save costs, especially buying and selling costs.

A combined entity is able to run integrated operations across the organisational structure, including manufacturing, purchase, sales, promotion, market research etc. In this way, companies gain competitive advantages over other companies. An organisation goes in for vertical integration when the cost of making the product in the house is cheaper than buying from the market.

Technological advancements

When two businesses combine for vertical integration, there are opportunities to adopt best practices of the two entities.

In a backward integration, the opportunities to exploit technological capabilities are higher because of the integrated production and distribution activities. Research and development function of the combined entity is provided with the enhanced synergy benefits.

However, the potential new innovations by the combined entity are dependent on effective coordination of marketing and technical functions. 

Supply-side benefits 

Sometimes companies that are seeking to acquire other company are mainly driven by the intention to assure the supply of their inputs. For example, a cell phone maker may prefer to acquire a business that is producing chips, batteries, processors. 

Businesses with high fixed costs are vulnerable, especially in times of supply-side disruptions, which can lead to severe damage in their operational performance, therefore need for higher capital might come about.

Entry barriers

Incorporating stringent entry barriers is perhaps the motive of many potential transactions in the M&A space. Competition regulators also scrutinise M&A deals to promote a business environment that does not suppress competition. 

The intensity of vertically integrated business dictates the level of barriers to entry as well as competition. When two players combine in an already concentrated, it would eventually discourage smaller new entrants in the market. 

But entry barriers could only be incorporated effectively when the vertical integration of two companies is successful. 

Disadvantages

Capital requirement

An acquisition is already a costly affair for most transactions, given that the bidder is paying a premium for potential future cash flows or earnings. After completing the acquisition, the entities engage in integration of not an only business process but cultural and values as well. 

The integration process also incurs additional costs of the combined entity. For companies seeking vertical integration, it becomes imperative to chart out operational efficiencies and potential cost savings to deliver better returns. 

Since investments and capital intensity is already at a high end in an M&A deal, the companies with vertical integration should focus on delivering expected synergy benefits. Otherwise, the chances of a successful deal are relatively lower. 

Reduced flexibility 

A combined, vertically integrated entity has less independent decision-making point of control. The objective of a vertically integrated business is to operate in a certain way. Businesses with relatively reduced flexibility may fail to adapt to ongoing changes in the industry. 

For instance, the rapid emergence of e-vehicles has posed an existential crisis for ICT engine businesses. Similarly, automobile parts manufacturers, especially engine part supplier, are facing an existential crisis. If a business has acquired engine part supplier, it may write off the acquisition in future. 

Reduced focus

A vertically integrated is expected to operate in a predetermined manner. This could derail the existing focus and specialisation of the entity or its business units. Effective vertical integration will likely require distinct approaches to managing business verticals. 

What is Data Mining? Data mining is a process that facilitates the extraction of relevant information from a vast dataset. The process helps to discover a new, accurate and useful pattern in the data to derive helpful pattern in data and relevant information from the dataset for organization or individual who requires it. Key Features of data mining include: Based on the trend and behaviour analysis, data mining helps to predict pattern automatically. Predicts the possible outcome. Helps to create decision-oriented information. Focuses on large datasets and databases for analysis. Clustering based on findings and a visually documented group of facts that were earlier hidden. How does data mining work? The first step of the data mining process includes the collection of data and loading it into the data warehouse. In the next step, the data is stored and managed on cloud or in-house servers. Business analyst, data miners, IT professionals or the management team then extracts these data from the sources and accordingly access and determine the way they want to organize the data. The application software performs data sorting based on user’s result. In the last step, the user presents the data in the presentable format, which could be in the form of a graph or table.         Image Source: © Kalkine Group 2020 What is the process of data mining? Multiple processes are involved in the implementation of data mining before mining happens. These processes include: Business Research: Before we begin the process of data mining, we must have a complete understanding of the business problem, business objectives, the resources available plus the existing scenario to meet these requirements. Having a fair knowledge of these topics would help to create a detailed data mining plan that meets the goals set up by the business. Data Quality Checks: Once we have all the data collected, we must check the data so that there are no blockages in the data integration process. The quality assurance helps to detect any core irregularities in the data like missing data interpolation. Data Cleaning: A vital process, data cleaning costumes a considerable amount of time in the selection, formatting, and anonymization of data. Data Transformation: Once data cleaning completes, the next process involves data transformation. It comprises of five stages comprising, data smoothing, data summary, data generalization, data normalization and data attribute construction. Data Modelling: In this process, several mathematical models are implemented in the dataset. What are the techniques of data mining? Association: Association (or the relation technique) is the most used data mining technique. In this technique, the transaction and the relationship between the items are used to discover a pattern. Association is used for market basket analysis which is done to identify all those products which customer buy together. An example of this is a department store, where we find those goods close to each other, which the customers generally buy together, like bread, butter, jam, eggs. Clustering: Clustering technique involves the creation of a meaningful object with common characteristics. An example of this is the placement of books in the library in a way that a similar category of books is there on the same shelf. Classification: As the name suggests, the classification technique helps the user to classify and variable in the dataset into pre-defined groups and classes. It uses linear programming, statistics, decision tree and artificial neural networks. Through the classification technique, we can develop software that can be modelled so that data can be classified into different classes. Prediction: Prediction techniques help to identify the dependent and the independent variables. Based on the past sales data, a business can use this technique to identify how the business would do in the future. It can help the user to determine whether the business would make a profit or not. Sequential Pattern: In this technique, the transaction data is used and though this data, the user identifies similar trends, pattern, and events over a period. An example is the historical sales data which a department store pulls out to identify the items in the store which customer purchases together at different times of the year. Applications of data mining Data mining techniques find their applications across a broad range of industries. Some of the applications are listed below: Healthcare Education Customer Relationship Management Manufacturing Market Basket Analysis Finance and Banking Insurance Fraud Detection Monitoring Pattern Classification Data Mining Tools Data mining aims to find out the hidden, valid and all possible patterns in a large dataset. In this process, there are several tools available in the market that helps in data mining. Below is a list of ten of the most widely used data mining tools: SAS Data mining Teradata R-Programing Board Dundas Inetsoft H3O Qlik RapidMiner Oracle BI

What is Earnings Per Share? EPS is the per share profit by a business in a given period. While analysing a business financially, it serves as one of the basic tools. EPS is calculated by dividing profits by total shares outstanding for a given period. EPS is reported on the profit and loss statement of an enterprise and works as a denominator for beloved price-to-earnings ratio (P/E ratio), used not just by novice investors but also fund managers. A business is required to generate sustainable earnings in its life cycle, and earnings or profits are essentially among major intend of a promotor. To know more about P/E ratio read: Understanding Price-Earnings Ratio But reported earnings of a business will likely differ from actual cash earnings because devising profits mandate broader accounting standards and principles to provide a fair picture of an enterprise. EPS, therefore, becomes imperative for investors, market participants and other users of information. EPS estimates are circulated by sell-side analysts to market participants. Financial Modelling is applied to arrive at the EPS estimates of future financial years, semi-annual periods or quarterly, depending on the reporting adopted by the firm. Analyst estimates are then collected by market data providers like Reuters, Bloomberg, IRESS to provide a consensus view of analysts on the business and its financials, including revenue, operating expense, earnings before interest and tax, profit after tax, EPS. Market estimates enable participants to evaluate the expectations of sell-side analysts from a particular company, sector or even index. Analyst estimates also indicate the divergence between an individual’s expectations and collective expectations of analysts that are tracking the company. An individual can, therefore, determine whether the stock of the company is undervalued or overpriced by the market against hi one’s fair value estimates that are based on the expectations from the company. More on EPS read: What Do We Mean By Earnings Per Share (EPS)? How to calculate EPS? Although general formula considers total shares outstanding in the denominator, it is preferred to use weighted average shares outstanding over a period because companies issue new shares, buyback or cancel shares. Net Income is the profit reported by a business after incurring income tax. It is also called as Net Profit After Tax. Dividends on Preferred Shares are paid to preferential shareholders because they have first right over the income of a business, but preferred shares don’t have voting rights like common shareholders or ordinary shareholders. Weighted Average Shares Outstanding is calculated after incorporating changes in number of shares during a period, and using weighted average shares outstanding provides a fair financial position of a company. Basic V/S Diluted EPS Diluted EPS is calculated after adding the weighted average number of shares that would be issued after the conversion of dilutive shares to weighted average shares outstanding. Dilutions can include share rights, performance rights, convertible bonds etc. Whereas Basic EPS is calculated by taking weighted average shares outstanding that incorporate changes to number of shares outstanding such as buyback, new issues etc. What is Adjusted-EPS? In a financial period, firms may incur one-time expenses or transactions that are not usual in the normal course of business. The objective of adjusted EPS is to arrive at a fair picture of the business, especially for financial forecasting. Extraordinary items are excluding from EPS to arrive at adjusted EPS figure. These items can include gain on sale of assets, loss on sale of assets, merger costs, capital raising costs, integration expenses etc. What is Normalised EPS? Normalised EPS is calculated to arrive at an EPS figure, which embeds the fluctuations in income due to business cycles or industry cycles. It also includes adjustments made for calculation of adjusted EPS such as one-time gains or losses. Normalised EPS is a useful measure for companies that are sensitive to economic cycles or changes in the business environment. By smoothening out the fluctuations, it provides a fair picture of the business. If a company has reported high normalised earnings over periods, it is considered that the company is less sensitive to changes in business cycles because of its stable revenues and income during the periods. EPS and Price-to-earnings ratio Calculation of price-to-earnings ratio requires EPS as denominator and price of the stock as numerator. EPS therefore becomes a very important financial metric for investors. EPS and price data also allows participants to compare the historical trends of the P/E ratio with the current market scenario and P/E ratio of the stock. How can increase grow EPS? Businesses can increase EPS by focusing on increasing their revenue, by improving operational efficiencies either by deploying technology to reduce cost, or negotiate better prices with vendors, operate in tax efficient manner, etc. Businesses can also improve EPS by undertaking corporate action such as buying back of shares. Read: Pros and cons of buybacks – Story of 5 Popular Stocks including Aurizon Good read: Every Doubt You Have On Earnings Per Share- Explained Right Here!

What are GAFAM Stocks? GAFAM Stocks are perhaps the most famous and sought-after stocks of the last decade. The dominance of these companies during the 2010s in the stock market will be remembered in the books and adages.  It is the creation of market participants that develop acronyms like GAFAM, which include five large American companies having dominance across most jurisdictions. GAFAM stands for Google, Apple, Facebook, Amazon, and Microsoft.  Over time these companies have gained dominance in their primary business. In addition, GAFAM stocks have been aggressive in expansion and entering new verticals.  Although there have been considerable acquisitions along the way, the investments in research & development and innovation have been at the forefront of the capital expenditure plans.  Google Officially known as Alphabet Inc., ‘Google is not a conventional company’ is a statement made by its founders in their early letters. It has not been a conventional company, indeed. Google has developed significant networking within its products.  As a dominant search engine of the world, Alphabet reaps large revenue through advertisements through its flagship search engine and other products. Over the years, the company has been able to expand in other verticals such as mobile phone operating system – Android, web browser through Google Chrome.  Alphabet has two operating segments. Under Google, the company houses Search engine, YouTube, Search, Google Play, Google Maps, Android, Chrome, hardware, Google Cloud.  In other bets, the company includes businesses that are not material individually. These businesses include Calico, Verily, Waymo, CapitalG, GV, X and more. Almost all revenue of Alphabet is derived by Google segment.  In 2019, Alphabet recorded revenue of $162 billion, and around $161 billion was derived from Google segment. Operating income of the company was $34.2 billion, while net income of the company was $34.3 billion.  Read: Unboxing Revenue Growth Streak of Google and Microsoft Apple  Established in 1977, Apple Inc. is a consumer electronic company engaged in manufacturing of various consumer products. Apple mobile phones are renowned across the world, and it also makes personal computers, wearables, tablets, and accessories.  iPhone is the flagship mobile operates on an in-house developed iOS operating system. Mac is a brand for its personal computers that are also used extensively across the professional domain. iPad is a line of tablets, which run on iPadOS.  Apple also sells other wearables and accessories that include Apple Watch, Apple TV, Beats products, iPod Touch, Airpods. The core strength of the company has been its capability to innovate and launch products continuously.  iCloud is its cloud service, and data of its products can be stored in the cloud. As a consumer business, it markets are focused small individual customers that do not constitute a material portion of revenue individually.  In 2019, Apple recorded revenue of $260.2 billion. Its operating income for the period was $64 billion, while net income was $55.25 billion.  Facebook  Facebook Inc. was established as a social networking website and has grown tremendously due to its strong networking effects. It enables people to connect with each other or in groups. Facebook is used in mobile phones, personal computers, handsets etc. It has been a great place to share opinion, ideas, videos and photos. With its large user base, Facebook and its products are used for advertisements. The traditional modes of advertisements have lost significant market share to companies like Facebook.  Instagram is also a part of Facebook. It is used by people across the world to share photos and videos. It also offers a similar type of services like Facebook and has emerged as a networking platform for digital creators and influencers.  WhatsApp is a messaging mobile phone application. It allows people to connect privately and is extensively used by people. Messenger is another application by Facebook that enables people to connect with family, friends, groups and businesses.  Oculus is the hardware business of Facebook that helps to connect people through its virtual reality products. A major portion of revenue is generated by marketing and advertisement through its products that are used by large scale potential consumers.  Watch: Facebook launching 'Shops' on its social Media Platform | Market Update Amazon Amazon.com, Inc. was established as e-commerce in 1994. The company serves consumers, sellers, developers, enterprises, and content creators. Amazon also provides advertising services to publishers, sellers, vendors, publishers, and authors.  It serves consumers through its online and physical stores. Amazon offers a range of categories and is has a strong online retail presence. It has been engaged in manufacturing consumer electronics such as Kindle, Fire TV, Fire Echo, Alexa, Ring etc.  Amazon Prime is a membership of the company that provides shopping benefits, streaming of entertainment content, including movies, original content. It intends to provide customers with low prices and home delivery of goods.  It also enables sellers to access Amazon marketplace, which includes stores and online website. Amazon earns through a percentage of sales, fixed fee, combinations etc. Amazon Web Services offers cloud service to a range of public and private enterprises to store data.  Kindle allows content creators to publish and sell content/books on Kindle and earn a royalty on sales. In 2019, the company recorded net sales of $280.5 billion. Operating income for the year was $14.54 billion, and net income was $11.59 billion.  Microsoft  Microsoft Corporation is a technology company that develops software, services, devices and solutions. Its products are extensively used by businesses and individual customers to operate personal computers.  Microsoft’s platforms allow improving small-businesses productivity, educational outcomes, driving competitiveness of large businesses. As a platform and tools provider, the company empowers enterprise and organisations of all sizes.  Now it is emphasising on innovation for the next phase of computing stage. Other than its legacy operating system, Microsoft provides cloud-based solutions, services, software, platforms, content, server applications, desktop management tools, software development tools etc.  It also designs and manufactures and sell devices, including gaming consoles, PCs, tablets, entertainment consoles, and related accessories. In 2020, the company recorded revenue of $143 billion. Operating income for the year was $53 billion, and net income was $44.3 billion. 

What is backward integration? Backward integration is a form of vertical integration which involves companies acquiring or creating processes enabling the company to produce its own inputs. These processes are those which the company had previously assigned to other companies up the supply chain. Complete vertical integration is achieved when a company is involved in all the stages of the production process. This can be achieved by the firm either by mergers and acquisitions with the companies in the supply chain, or by starting its own subsidiary to perform the tasks which had formerly been assigned to these companies. Copyright © 2021 Kalkine Media Pty Ltd Backward integration is a form of vertical integration used to make the business more competitive. What are some examples of vertical integration? Vertical integration can be better understood with an example. Consider an oil refining company like Marathon Petroleum Corporation that depends on another firm for providing it with crude oil. Marathon refinery purchases raw oil from other oil exploration companies and is only engaged in refining the oil and selling it. However, if Marathon were to acquire or merge with these oil exploration companies then it would be called a backward integration for Marathon. Consider a restaurant engaged in the production of wheat and potato-based products. The firm usually acquires these products through long-term contracts with farmers or wholesale grocery suppliers. If the firm now decided to start its own plantation growing wheat and potatoes, then it would be a backward integration. Here the firm has chosen to create its own production process without having to merge with or acquire any other company. This gives the firm endless possibilities to change how these inputs are processed. For instance, the firm can choose to opt for organic farming, which it could then advertise to its customers. How is backward integration different from forward integration? A company’s supply chain refers to the different stages involved in achieving the final good. The processes lying upwards in the chain are the initial stages while the processes lying further down are the final stages including the sale of the product or service.  Backward integration involves integrating those production processes into the company’s operation that lie on the upper side of the supply chain. Whereas forward integration involves the integration of those processes into the firm’s operation that lie on the lower end of the supply chain. Forward integration involves companies acquiring or merging with those firms that are engaged in the distribution or in the retailing process of the product. For example, consider a cheese processing company that sells its product to a retailer for resale. If the company decides to set up its own retail chain, or its own digital platform to sell its cheese then it would be forward integration.  What are the advantages of backward integration? Higher control: Integrating upper-level supply chain processes into a firm’s operation gives it higher level of control over how the final good turns out. This also allows companies to conduct their supply chain management more efficiently. Thus, there can be higher level of differentiation in the final goods as compared to other competitors. Additionally, the company would have a fixed supply of input when the subsidiary is engaged in raw material production. Competitive Advantage and Barriers to Entry: Acquiring a company through backward integration can allow access to exclusivity of the supplier. Other companies may no longer approach the supplier once the firm acquires or merges with it. This adds a competitive advantage to the firm and creates barriers to entry for other companies. Cost Cutting: When a raw material producer supplies it to companies lying lower on the supply chain, it would charge a mark-up over the actual cost of production to gain profits. However, if a firm were to become its own input supplier, then there would be no mark-up costs involved for it as it is producing for itself. What are the challenges with backward integration? Copyright © 2021 Kalkine Media Pty Ltd Lack of competitiveness: Removing competition by acquiring the supplier could sometimes have more adverse effects than benefits. Reduced competition could make a firm less competitive and hence less efficient. This could reduce the innovation in the firm and cause it to produce poorer quality products. Financial requirement: To acquire with a full-fledged supplier, firms must have adequate capital. Thus, backward integration can be a huge investment for firms. Many companies may consider debt financing which could end up hurting their balance sheet.

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