How Vertical Integration Is Changing Financials

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If you've been watching the market recently, you've probably noticed plenty of vertical integration. Companies across all kinds of different sectors are joining up so they can take advantage of low interest rates before they get hiked.

In this week's episode of Industry Focus: Financials, host Michael Douglass and Motley Fool contributor Matt Frankel take a close look at how vertical integration is shaking out in insurance, banking, and real estate. Several insurers are taking a significant interest in reinsurance. A number of big banks are providing their customers with more products and services than ever before. Some real estate investment trusts are absorbing subfunctions like property management into their company. Find out how these strategies present several big risks and some big opportunities for the companies that are trying them.

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A full transcript follows the video.

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This video was recorded on April 9, 2018.

Michael Douglass: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Monday, April 9th, and we're talking about vertical integration. I'm your host, Michael Douglass and I'm joined by Matt Frankel. Matt, great to have you back on the show!

Matt Frankel: Always fun to be here!

Douglass: Fantastic! We wanted to talk about vertical integration a little bit because, if you pay attention to financial news at all, there have been a lot of mergers and acquisitions across all kinds of different sectors. And what you really see across the board is companies trying to take advantage of the low interest rate environment one last time before growth in the economy really pushes the Federal Reserve to continue raising interest rates in a way that is going to make cheap debt increasingly difficult to come by. And those mergers and acquisitions increasingly are looking like vertical integration plays. If you think about in healthcare, you see it with CVS and Aetna, and a lot of the other healthcare mergers and acquisitions. You see in a lot of other sectors, too. And frankly, those are just accelerations of trends we've seen toward vertical integration across the board in a lot of areas. You think about Walmart. One of the things that really made Walmart powerful in the first place was that they really controlled so much of their supply chain. We see this happening in financials as well, where there's just this integration across the board.

There are three main areas we want to talk about this where we're seeing this in financials either occurring or accelerating or just something that's been the case for a while. The first: insurance. I think Warren Buffett's Berkshire Hathaway is, of course, the classic example of an insurer that is also in reinsurance.

Frankel: Yeah. They're actually in a whole lot of businesses. [laughs]

Douglass: [laughs] Yeah, that's fair.

Frankel: But, in insurance, there's generally two transactions that take place. It's not just you paying a premium, as most people think. When customers pay a premium, say for auto insurance, like in Berkshire Hathaway's case, Geico, a lot of times the insurance company will purchase what's called reinsurance to lay off some of their risk. A big famous situation in insurance planning is Hurricane Andrew. What was that, about 30 years ago, almost, in Florida. A lot of insurance companies completely went bankrupt because they couldn't afford the massive losses they were sustaining. So, reinsurance allows them to purchase insurance on their insurance to prevent from catastrophic losses.

So, what a few companies have done -- Berkshire is not the only one. They're very notable example. Actually, Geico's their most well-known insurance company, but most of Berkshire's insurance business is reinsurance. A couple of other companies have done this as well. Markel is a big one. They're a very unique insurance play. They have a specialty insurance division, they insure risks that are really impossible for anyone else to gauge, but they do really well. And they also have a big reinsurance business. Two others I can think of off the top of my head are Aspen Insurance Holdings and XL Group, both of which have substantial businesses in both.

Where this helps is when you have, say, like we just had over the summer, where you have three major hurricanes, wildfires in California, a lot of insurance claims, the reinsurance side of the business is really going to take a hit. But the traditional insurance will end up being OK because of reinsurance. So, it kind of helps balance out the risk these companies are taking on.

Douglass: Yes, as long as it's diversified across different product lines, right? If you do, for example, home insurance, then you do reinsurance for that kind of insurance, that might be a little bit problematic. But as long as you're working across different sectors, and sectors that are not highly correlated to each other, I think that's where you can get that balancing.

And we've seen this happen with banks. Head over to Goldman Sachs (NYSE: GS) just for a minute -- and we'll be talking more about them in a bit -- where their trading desk does very well when their wealth management side of their businesses is maybe struggling a little bit. And of course, the inverse occurs, as well. So, there are some benefits there to the business in terms of stability because of that ability to diversify their risk a little bit. It's an interesting trend, and I think it's something that, certainly Berkshire and Markel have made it look, well, maybe not easy, [laughs] but they certainly look pretty good while doing it. I think one of the big questions we'll have to ask long-term is some of the lesser-capitalized insurers, what this looks like for them long-term.

Frankel: Yeah, I would definitely agree with that point.

Douglass: Cool. Let's turn to our second area. I promised we were going to get back to banking, and lo and behold, here we are. Banking. When you look at how the banks are expanding and changing, particularly the big banks, but I think we see this across some of the smaller regional ones as well, there is a vertical integration aspect here, where banks are increasingly trying to be all things to all people. We talked about Goldman a little bit earlier. Let's talk about Goldman a little bit more. They are traditionally an investment bank. Their focus is on M&A, wealth management, and their trading desk. And yet, they're now doing consumer loans with Marcus. And you've also seen, in general, the lines between the different types of big banks -- again, your commercial banks, investment banks and universal banks -- kind of blur as they all try to do all of the things a little bit.

Frankel: Yeah, definitely. The problem with not being in all lines of banking these days is that people want somewhere where you can do everything in the same place. In Goldman's case, their investment banking business was great as long as most of the other major banks didn't have investment banking divisions. But now that Bank of America has Merrill Lynch, Wells Fargo (NYSE: WFC) has Wells Fargo Advisors, and I could go on, JPMorgan is obviously an investment bank. But now they're trying to give their customers more of a one-stop experience so they don't say, "Well, OK, I'm going to go to Wells Fargo where I can have my wealth management needs met and have all of my other banking needs met in one place."

Now, Goldman's a long way from offering everything a banking customer could need, obviously. There's no Goldman Sachs branches in my city, I don't think there are in yours. But, that's kind of the direction it's going, and I wouldn't be surprised if it gets there someday, where there's a Goldman Sachs branch in Alexandria, where Michael is.

Douglass: Yeah. And I mean, this makes sense in a lot of ways, right, that the banks are trying to do this, because they're trying to meet their customers where they are. Time is a valuable commodity, and one of the things with the advent of the internet is that it's become so much easier to save time with things, so we prize it, because we're trying to find ways to reduce all these extra errands and all this extra stuff that we have to remember and do because there's so many other things now that we can remember and do and learn about. So, banks really have to try to serve that.

One of the problems for banks in approaching this is that they risk getting into something that they're not very good at and making a big mistake. Particularly when you think about a bank that historically hasn't made loans a lot, like, for example, a Goldman, and then they start making loans, you can see why that might become a bit of a concern for investors in that bank, given that they just don't have a ton of experience in it, compared to their other business lines.

Frankel: No, that's true. There's definitely pros and cons. There's what you're referring to, which is a general loss of focus on their core business. But there are trade-offs, especially if they're going for growth through acquisitions, adding another segment. A lot of economies of scale, I guess you would say, by going from a bank with -- I mean, with the ones we're talking about, $1 trillion of assets to $2 trillion of assets, there are some economies of scale to be had there.

And it also lets you cut out the middleman. Even before banks started universally integrating, they would have a wealth management partner they would refer customers to, a place they would refer customers to for loans if they weren't already making them. So, it lets them be the middleman and pocket all the money for themselves from their customers. Banks refer to that as cross-selling.

It's just kind of a trade-off. For the record, I'm not doubting Goldman's experience to assess risk. They're pretty good at that in other areas of their business. But that's a very good point. I'm trying to think of a purely commercial bank ... like, if U.S. Bank started a big investment banking division, it would be a little suspicious, or at least make me a little bit wary as a shareholder, if they were going to completely get into a new line of the business.

Douglass: Yeah. It's one of those things where, as you noted, in some ways, these are the sorts of things that follow cycles where companies will bulk up, and then they will slim down, and they'll bulk up and they'll slim down. Certainly, that's been the case in healthcare. Anyone who's a follower of big pharma has seen this cycle play out a few times in the last couple of decades. I think one of the big questions we'll have to ask with the banks, is this a permanent thing? I think the answer is yes, because people are looking to simplify their finances, so they want a platform that can do all the things. But it's still, I think, to some extent, also an open question. It's certainly possible that we could be wrong. It's one of those things where time will tell.

Frankel: Yeah, definitely. Vertical integration for some of the big banks, too, it's worth mentioning, is one of their big advantages over the smaller online banks that can offer better interest rates and better loan rates that we've been talking about in other episodes recently. For example, BofI is one of our favorite banks, and I use Wells Fargo because I like having a safe deposit box and I like being able to go inside and talk to a teller if I need to. And I get all of my banking needs met through Wells Fargo, whereas with BofI, I could get a great savings account and maybe a mortgage, but that's about it. So, it's part of making their advantage as the big players in the industry, too.

Douglass: Yeah, absolutely, I think that makes a lot of sense. Let's turn to our third area where we're seeing this beginning to happen, which is, oddly enough, in real estate investment trusts or REITs. Now, I'm saying "oddly enough" because my tendency in REITs has been to really focus in on companies that are really good at one thing, and that one thing is figuring out what properties are the right ones to buy and then -- well, OK, I guess two things. Figuring out which properties are the right ones to buy and leasing them out effectively.

And I tend to actually favor companies that outsource all the other stuff. As a REIT, you don't have to be a great property manager, because there are other people who are very good at property management. But, certainly, there is an argument in the other direction, and you actually see some REITs heading in that direction. Welltower (NYSE: WELL) is a great example of a company that is really starting to try to integrate a lot of these different functions under its umbrella.

Frankel: Yeah, Welltower and a lot of the healthcare REITs, on that note, they're structured more as operating partnerships than just landlord-tenant relationships. In Welltower, it's actually a 50-50 mix, roughly, of their senior housing properties are triple net leased, and the other half are operated in partnership with some of the best senior operators in the business, Brookdale being one of them.

Douglass: Triple net leasing, by the way, as background for anyone who's not familiar, essentially means that the tenant is paying all of the extra stuff associated with occupying the property. That's usually utilities, maintenance, insurance, and often taxes.

Frankel: Yeah. And by the way, that produces a pretty low-risk business model. You want to look for triple net REITs if you want to see ones that'll get through the tough times. REITs are kind of my favorite thing. A lot of people think it's weird how much I like REITs.

Douglass: I don't think it's weird. I like them, too. [laughs]

Frankel: But, back to the healthcare and vertical integration. Recently, there was actually an interesting news story where Quality Care Properties, which was a spinoff of HCP, one of the major healthcare REITs, they announced they are absorbing, as a result of back rent owed, HCR Manor Care, which is the second-largest skilled nursing facilities operator in the country, giving up their REIT status to do so. So, they're actually going to be in the skilled nursing business, in addition to owning the properties that the skilled nursing facilities are operating out of. So, that's actually a really prime example of vertical integration, a company actually willing to give up its REIT status to have several layers of the supply chain.

Douglass: Yeah. So, when we think broadly about vertical integration, I think one of the key questions that people can ask is, is this a good idea or is this not a good idea? And I don't think we can even say across insurance or banking or REITs whether it's a good idea or not. So much of it is going to depend on execution and on the company.

And I'll just give you an example outside of the sector. In healthcare, Johnson & Johnson has done a great job of the conglomerate model. It's worked really, really well for them. GE has done maybe not as great of a job of the conglomerate model. It has not worked as well for them. And I think that has less to do with the particular sectors that they operate in and just more to do with how management has approached things, how thoughtful they've been about capital allocation, and just how wisely they've led the business. And so, when thinking about this in insurance, in banking, in REITs, or even across the umbrella of all three of those -- financials, as we call it -- I don't think there's necessarily a universality here. I think the question is really a question of execution.

The one area where I'll say differently with that, though, is probably banking. It's probably a good move for them to do it, because that's where consumers are going. Consumers want an easy place to just do all their things. I bank in two different places. The only reason I do that is because one of them is really good at one thing and one of them is really good at another thing. I still find it frustrating. If I did not have to do that, I wouldn't. But, for me, the costs are worth the benefits. But, generally speaking, people just want to have all their stuff in one place.

Frankel: Another good point is, with banks, it's not just through acquisitions, usually. Usually, banks are adding products and services to their existing business. It's not that they're going into debt, or trying to justify things with synergies, which we are not big fans of. They generally just add to their business model, which is why it's kind of a different animal in the banking sector.

Douglass: Yes, that's a good point, and yeah, that's actually a good additional point to make here, which is that one of the questions you have to ask when looking at vertical integration and how a company is doing it is how they're doing it. Are they doing it organically? Are they doing it internally? Are they doing it through acquisition? Both have benefits and drawbacks.

The benefit with organic is that you really probably very well know the employees that you're using to grow that new piece of the business, and it gets designed the way you want it. Flip side of that, it's bootstrapped, and so things get designed, well, as well as you can do them -- which, maybe, if you're not an expert, isn't necessarily that well. Whereas on the flip side, when you grow by acquisition, you are usually buying a stable business, hopefully, or at least a business that's already at some scale and already has some stuff. There are inevitably some culture conflicts as you integrate that business into yours, but it's already at scale, and it already works in some way.

And so, there are benefits and drawbacks to both. And so, I think, as investors, we just have to be really, really thoughtful about approaching this, and avoid a lot of, "vertical integration is good," "mergers and acquisitions are good," or the opposite, that either of those is necessarily bad. It really so much is situational.

Frankel: Yeah, you definitely have to take it on a case by case basis.

Douglass: Yeah, for better or for worse. Folks, that's it for this week's Financials show. Questions, comments, you can always reach us at industryfocus@fool.com. As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so, don't buy or sell stocks based solely on what you hear. This show is produced by Austin Morgan. For Matt Frankel, I'm Michael Douglass. Thanks for listening and Fool on!

Matthew Frankel owns shares of Bank of America, Berkshire Hathaway (B shares), HCP, and Quality Care Properties, Inc. Michael Douglass owns shares of Berkshire Hathaway (B shares), BofI Holding, and Johnson & Johnson. The Motley Fool owns shares of and recommends Berkshire Hathaway (B shares), BofI Holding, Johnson & Johnson, and Markel. The Motley Fool has the following options: short May 2018 $140 calls on Johnson & Johnson. The Motley Fool recommends CVS Health and Welltower. The Motley Fool has a disclosure policy.