High Commodities Prices Put Vertical Integration in Vogue: Is That a Good Thing?

Includes: BRDCY, LUV, MT, TM
by: Robert Zenilman

Rob Zenilman submits: In today's Wall Street Journal, Timothy Aeppel's article A Hot Commodities Market Spurs Buying Spree by Manufacturers details how high commodity prices are driving a wave of vertical integration - companies buying their suppliers in an attempt to control their raw material costs. Examples include:

  • Armored car & bullet-proof vest maker Armor Holding (AH) recently bought Integrated Textile Systems, its supplier of super-strong fibers.
  • Mittal Steel (NYSE:MT), the world's largest steelmaker is aiming to to be mostly self-sufficient in iron-ore by 2010.
  • Russian steelmaker Novolipetsk Steel wants to be totally self-sufficient in raw materials.
  • Japan tire manufacturer Bridgestone (OTCPK:BRDCY) purchased an Indonesian rubber plantation, and is investing in plants for other raw materials it uses.
  • In order to ensure a reliable supply of batteries for its popular hybrids, Toyota (NYSE:TM) has taken a controlling interest in its main supplier for that product.
Comments: It will be interesting to see how these vertical integration plays work out in the long run. In the past, conventional wisdom on Wall Street has been against vertical integration, given the inherent inefficiencies of running such diverse businesses. What might make more sense in a rising commodity price environment is to lock in costs from suppliers. Look at Southwest Airlines (NYSE:LUV). In 2006, Southwest will be paying $31/barrel for 65% of its oil requirements, less than half the current price. Southwest's fuel hedges run through 2009, when it will pay $35/barrel for 25% of its jet fuel requirements. This makes life even more difficult for legacy carriers, whose poor financial predicaments have prevented them from entering into such agreements. The advantage for Southwest, is that it can focus on what it does best - flying people around the country at affordable rates. Maybe the old conventional wisdom still holds.