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This article explores the strategic rationale that is driving a growing number of Consumer Packaged Goods (CPG) company boards to approve vertical integration of their supply chains. Key drivers include strengthening ESG performance, mitigating climate risk, addressing investor activism, and securing supply chains in a geopolitically polarized world.
Key takeaways:
- Vertical integration is a clean and efficient way to ensure supply chain adopts your ESG strategy and reduces third party litigation exposure
- Vertical integration can serve as a means to address the increasing trend of investor activism
- Need for supply chain security in geo-polarized trading world has opened opportunities for vertical integration and shortening supply chains will be essential in reducing supply chain risk exposures
- Geopolitical risks have led companies to vertical integration as well as China+1 strategies, especially with a second Trump administration promising higher tarrifs on imports from China
Vertical integration is a complex and often resource-intensive strategy with significant financial implications. Companies don’t take it lightly. Boards of these companies approve these transactions only after tremendous due diligence, debate, and scrutiny. The cost and benefit associated need to be clear to shareholders and the approval of such a transaction needs to have a strong strategic imperative.
Supply chain challenges remain a top concern for CPG leaders. More than six in 10 (62%) CPG executives anticipated challenging supply chain issues in 2023, and in response more than half (52%) worked towards shortening their supply chains to de-risk.
Sometimes, gaining ESG or supply chain security can be a strong strategic imperative. But directors need to ensure that the narrative for such a transaction is clearly stated as the results might not be near-term.
A few notable examples:
While not widely prevalent, there have been some instances of vertical integration in CPG companies driven in part by Environmental, Social, and Governance considerations. A few examples are:
- Coca-Cola has long been vertically integrated in its bottling operations, but in recent years, it has extended this approach to packaging. In 2020, the company announced a paper bottle prototype as part of its World Without Waste Initiative. This is seen as a step towards vertical integration in the packaging aspect of their business. While short term reaction in 2020 was mixed, with investment viewed as an increased cost, the market generally reacted positively as part of the company’s overall sustainability strategy
- Unilever acquired Pukka Herbs, an organic herbal tea company, in 2018 to expand its sustainable tea offerings. While the stock price didn’t show any significant immediate impact, it was generally well-received by investors as it contributed to Unilever’s overall sustainability strategy
- L’Oreal has been investing in biotechnology startups and companies that produce sustainable ingredients like Thayer’s Natural Remedies. The stock price has shown steady growth over time and reception from investors has been positive
These companies showcase that some CPG companies are using vertical integration as means of shoring up ESG commitments, performance, and deliverables. ESG goals continue to be of focus for profitable CPG companies. In a recent 2023 industry outlook, almost all CPG companies (97%) have made it a priority to become more sustainable (compared to 58% of other industries). Also, they are more likely to invest in ESG reporting (83% vs. 50%) as well as prioritize increasing the company’s positive impact on society (76% vs. 50%).
Even with some of the anticipated benefits of vertical integration, it is important to underscore that full vertical integration is still relatively rare in this sector, and these moves are often limited to specific product lines or initiatives. This trend has been more visible in the past 5-10 years as the need for ESG is becoming prominent. The question that arises is why boards of directors are approving such transactions.
Why are Boards approving such transactions?
In most cases, the boards of these companies likely approved these integrations primarily for the delivery of their overall strategy and to accelerate established ESG goals.
- ESG credentials can enhance brand reputation and appeal to consumers and investors who are more socially conscious. While providing cost-saving opportunities, it also helps with quality control, compliance mechanism to supply chain policies, and opportunity to innovate and differentiate faster
- Anticipating more stringent environmental regulations, this mechanism also helps drive compliance and accelerated assurance for the board
- Greater control over the supply chain can help mitigate and address some of the risks identified to the board on the Enterprise Risk radar. It helps in sourcing but also helps remove risks of ESG related controversies and geo-political risk
- Increasing climate risks threaten the bottom line and can include the likes of droughts in Mexico and the Panama Canal, forecasts of an unusually active hurricane season, and record-setting heat across the US (and globally). All of these climate issues distort productivity, put physical assets at risk, and increase costs across supply chain nodes. Moreover, alongside safeguarding their own facilities, companies must monitor their supplier’s climate resilience. In 2023, Resilinc, a supply chain management firm, has sent its clients 130% more weather-related alerts of potential disruptions this year compared with the first half of 2023
- With many companies embracing a China+1 strategy, companies look to diversify supply chain nodes outside of China given increasing political tension and tariffs between Washington D.C. and Beijing
At the end of the day, directors are driven by the performance of the company in the sector and seek returns for shareholders. In general, companies with a focused ESG discipline and performance have shown resilience in stock prices, especially during market downturns. Usually, drawing a straight line between ESG initiatives and stock performance becomes complex, but in the long run, investors value companies that have these goals and are working towards addressing them in a holistic manner, including through inorganic opportunities.
Investor activism in relation to ESG driven vertical integration
Investor activism in the CPG sector often focusses more on overall sustainability strategies rather than specifically on vertically integrated performance. However, these broader sustainability pushes can indirectly lead companies to consider vertical integration as a means to achieve ESG goals. In some cases, investors have noted that these transactions have helped deliver the company’s ESG strategy and performance. In other cases, companies were able to address activist demands while still making incremental improvements in their sustainability practices.
- BlackRock’s Influence: the world’s largest asset manager, has been pushing companies to improve their ESG performance. This pressure has influenced many CPG companies to reconsider their supply chain strategies and, in many cases, introduce vertical integration as a mechanism
- Takeovers neutralized: In 2017, Kraft Heinz’s attempted takeover of Unilever was partly rebuffed due to Unilever’s commitment to sustainability. This event, albeit not a direct activism, highlights how a company’s ESG strategy can influence investor actions
- As You Sow: While not directly advocating for vertical integration, the active filing of shareholder resolutions by this non-profit organization related to recycling ad sustainable packaging has led companies like Coca-Cola, PepsiCo and Mondelez to take more control over their packaging processes and materials
Vertical integration helps boards improve supply chain transparency and control and also helps address Scope 3 emissions, greenhouse gas emissions that are indirectly caused by a company’s activities but are not directly produced by the company. It is also helping accelerate enhanced ESG reporting and to gain some competitive advantage. As seen in the recent Boeing $8.3B acquisition of its largest supplier Spirit AeroSystems, the company stated that this integration helped them address safety and quality issues, a topic that the Boeing board has come under significant pressure. But in today’s world of geo-political divide, vertical integration helps companies address questions regarding the safety and security of their supply chains.
Vertical integration to address global trade war situation
Like every other sector, the CPG industry will continue to be significantly impacted by the geo-political trade situation with increased costs, upstream and downstream disruptions, changing pricing strategies, recurring need for product reformulations, and relocation of production. To sum it up, the world around us is dealing with US-China trade tensions, Brexit, US-EU trade disputes and the relatively newly formed USMCA. With this volatile world, one thing remains constant: established supply chains and trade routes will have to change. Leading CPG companies will proactively plan and seize opportunities related to these fast-moving dynamics.
P&G reported that performance was impacted by $100M annually related to tariff costs. Coca-Cola faced higher costs for aluminum used in cans as section 232 tariffs were imposed on Chinese metal. Newell Brands estimated a $100M hit from tariffs in 2018 for its brands like Rubbermaid, Sharpie, and other household brands.
CPG companies are now changing their manufacturing strategy to address this geo-polarized world. Hasbro and Mattel reported moving 30% of its production out of China in 2020. Coca-Cola’s investment in Philippines for plastic recycling in 2020 also helped reduce reliance on imported materials that could be subject to tariffs. Hershey’s work in West Africa helped them gain more control over its cocoa supply, reducing exposure to potential tariffs on imports. Tyson acquired Thai and European operations of BRF S.A., a major food company to increase control over its international supply chain, helping reduce the impact of US-China trade tensions. And Anheuser-Busch Inbev (AB Inbev) has been increasing its investment in hop farms and barley malting facilities, to reduce exposure to potential tariffs on agricultural imports.
In making these moves, boards not only addressed concerns about trade-war implications, but also helped address many of the governance related risks that their supply chains were coming in collision path for. And their investors have rewarded them accordingly.
Actions boards can take:
- Consider how vertical integrations bolsters the supply chain and integrates with the company’s ESG strategy, which will reduce reliance on third parties and mitigating litigation risks
- In a geopolitically polarized world, assess opportunities to shorten and secure supply chains to reduce exposure to trade risks and ensure stability
- Incorporate climate risk assessments into vertical integration decisions to safeguard assets, ensure supply chain resilience, and protect against disruptions caused by extreme weather events
- Monitor and adjust strategies in response to trade tensions, tariffs, and changing international relations by investing in regional production and sourcing strategies to mitigate costs and disruptions
Questions for the boardroom:
- Have we considered the right places for vertical integration that can give the trifecta effect of ESG performance, tariff reduction, and supply chain security?
- If full-on vertical integration isn’t viable, what about product-level integration strategy? Where might we de-risk, shorten supply chains in a growing product line?
- How can we ensure that shareholders are aware of the full strategy for long-term results vertical integration?
- Can supply chain fractures open opportunities for activism and when is the right time to integrate?
- How can vertical integration help reduce risk from geo-political issues for the company?
- Where do we face physical climate risks and how can we vertically integrate our supply chains to reduce these risks?
- How can we integrate vertical integration with any existing China+1 design efforts?
Additional Telesto resources:
Telesto Strategy supports Corporate Directors in CPG to mitigate ESG and climate risks, stay ahead of changing regulatory regimes, and enhance disclosures and reporting in the face of increasingly complex environments. See additional resources to equip Corporate Directors:
- Navigating corporate climate action under a second Trump administration – 7 focal points for business leaders – Telesto
- Making Sense of Corporate Sustainability and ESG’s History: A Primer for Board Members
- Preparing for Climate Litigation: What Board Members Need to Know – Telesto
- Atlas, our sustainability and ESG training for boards, equips corporate directors and leaders with the insights and knowledge necessary to stay up to date, mitigate risks, and seize business opportunities associated with sustainability, climate, and ESG