[Thesis] Horizontal Expansion

Expanding Horizons

As soon as I became the Director of M&A at TOTVS, I found myself in a cold, formal law office, about to close a crucial deal. It was the purchase of a direct competitor from Goiás, which also offered ERP solutions. But was it just a geographic expansion? What was the real meaning of this acquisition?

I soon discovered that this competitor’s key differentiator was its exceptional expertise in the distributor segment, an area in which we weren’t particularly strong. This experience marked my first deep dive into acquisition theses and introduced me to the strategy I would apply most frequently in the following months: Horizontal Expansion.

Each merger or acquisition process is based on at least one thesis. The thesis defines the rationale, explaining and making sense of the movement from a strategic standpoint. Here at 'Exit Strategy,' we'll delve into various theses.

In this article, we will explore the Horizontal Expansion thesis, a strategy in which I’ve gained significant experience on the buyer's side. As a former Director of M&A at TOTVS, a software company focused on small and medium-sized businesses and organized for many years into verticals or segments (such as Education, Manufacturing, Construction and Projects, Financial, and Retail), this strategy became my go-to in the mergers and acquisitions game.

What is Horizontal Expansion?

This strategy consists of tailoring software offerings in a specialized manner to better serve each of these segments. In the mindset of the M&A department, horizontal expansion involved opening new segments or reinforcing others where we were not as significant.

One of TOTVS's major competitors at that time, Linx, was focused on what for TOTVS was just the retail segment. For the competitor, this was seen in an even more fragmented and specialized manner: dealerships, restaurants, construction materials, etc. Linx itself used acquisitions to establish many of its software verticals (its segments).

Competition is an important strategic driver for any corporation. And a good competitor challenges the pride of the board and key executives. For TOTVS, it was no different, and strengthening our retail segment through acquisitions became one of the priorities during my tenure.

Practical Examples

What does this mean in practice? We made three significant acquisitions as part of this strategy during that period:

1- PC Sistemas, one of the leaders in the distributor segment, for BRL 80 million (plus up to BRL 15 million in earn-outs, i.e., linked to the achievement of targets) in January 2013.

2- RMS, a top-of-mind company in the supermarket segment, for BRL 37.4 million (plus up to BRL 5 million in earn-outs) in July 2013.

3- Virtual Age, a leader in the retail textile segment, for BRL 50 million (plus up to BRL 25.1 million in earn-outs). Another more expressive example of this strategy was the acquisition of Bematech, but it involves various other elements that I will address in future theses.

But is this really horizontal expansion?

These examples might prompt the question: "If TOTVS was already operating in the retail segment, is this a horizontal expansion?"

Our solution for retail was less specialized than that of each of these acquired players. Therefore, yes, we were entering a specialized subsegment with each of these acquisitions. And when you sit in a competitive situation to acquire an ERP and your competitor has greater functional adherence to your client's needs because they specialize in your subsegment, you truly understand the rationale behind this acquisition thesis.

International Examples

A great example in a somewhat similar segment is Oracle's acquisition of Netsuite for USD 9.3 billion in 2016. Oracle, then a giant in the B2B software world, acquired Netsuite, which offered CRM, a different category of software where Oracle was not a significant competitor, thus entering a new market or vertical with this move.

SAP (ERP) purchased SuccessFactors (HR software) in 2011 for USD 3.4 billion, entering another segment where it was not significant.

The size of the markets in the USA is significantly larger than in Brazil, and therefore the companies and acquisitions tend to be significantly larger as well.

Horizontal Expansion vs. Product Diversification

Another thesis card we will study is called Product Diversification. What is the difference between entering a new market/segment and diversifying products? The segment or market is defined by who buys the product. In the case of diversification, different products may be acquired to sell to the same buyers. That is, the product diversification thesis may involve a play on synergy through cross-selling of products. In the case of horizontal expansion, as we are talking about different customers, such synergy is less likely.

The examples of Netsuite + Oracle and SAP + SuccessFactors might even cause confusion: "Isn't this just product diversification?" That's why we'll use them to clarify. Within a company, the departments that purchase CRM and HRTech are different from those that buy ERP. Although the buying client (the company) may be the same, CRM is typically defined as a different market, partly for this reason.

Strategic Rationale for Horizontal Expansion

If it's not cross-selling, what is the strategic rationale for horizontal expansion? This is a market diversification strategy, which can include the following advantages:

Revenue Diversification

Reducing dependency on a single revenue line moves towards opening up other lines. For a company that is already organized in verticals (or is focused on a single segment), expansion to others is a form of diversification. Different segments might require different pricing models, have different seasonality, among other drivers for which this diversification can be very positive.

Market Risk Diversification

One of the motivators for diversification can be a perception of risk. High dependency on one or a set of customers carries a risk associated with that segment. If there is some macro-economic situation that harms the sector, the company can be significantly impacted.

Expanding your operational area to other segments diversifies the risks. Just like seasonality, expansion can be designed to counter these risks. Complementary segments where one performs well when the other does poorly bring "anti-fragile" stability and can justify acquisition movements.

Accelerated Growth

At TOTVS, when we began to focus on strengthening our retail vertical, the growth of the sector was one of the attractions. At the time, the company was highly dependent on the industrial sector, which we called Manufacturing. This segment had been experiencing slow growth for years, while retail was undergoing a period of rapid expansion.

This created a dynamic where the major competitor, Linx, much more focused on retail, was growing faster, largely driven by the growth of the sector itself. And since growth is one of the factors for evaluating companies on the stock market, Linx had an advantage over TOTVS.

Growth, therefore, was one of the motivators for our strategy of horizontal expansion.

Competitive Leverage

When competition in a sector is very fierce, entering another less competitive sector through an acquisition or merger can be a significant strategic relief. Most of the time, the motivators for this movement are the competitors. But a high concentration of market share by a single company can also justify inorganic horizontal expansion (through merger or acquisition). One reason could be regulation. Companies with a strong dominance in a market (like Microsoft in computer operating systems or iFood in food delivery) may face restrictions in their original segment. In the case of expansion, acquisitions can and should be blocked by antitrust bodies like CADE.

In cases like these, expanding horizontally to a lateral segment can be a way to escape this scrutiny.

How can my company fit into a horizontal expansion?

The million-dollar question is: how can you make your company a target for another's horizontal expansion?

Vertical Focus

The first answer is to focus on a segment. The more focused, the easier it is to be complementary. If you are in a single segment, your company can be complementary to all those that do not operate in the same one. As you spread across two or more segments, you start to compete with all the companies that operate in them and stop being complementary to them, thus having less appeal from the perspective of horizontal expansion strategy.

Focus is a good strategy, especially for startups. Starting in a small market niche is a recommendation from many investors to differentiate in the early stages. All the examples of companies that I mentioned that were our acquisition targets at TOTVS were very focused on their segments and therefore had enviable, or rather desirable, commercial positioning and performance, which is the adjective we want to develop for your company.

Complementary Specialization

Even if you have major competitors in your segment, can you be more specialized than them? If so, you can still be complementary. Returning to our examples, we initially viewed retail as a segment, but when we started looking at more focused companies, we found acquisition targets specialized in supermarkets, dealerships, textile retail, restaurants, etc. Possible objects of desire for a horizontal expansion that brings complementarity to a company that operates with less specialization in a macro-segment.

Implantable Idea Pitch

The IIP (Implantable Idea Pitch) is a concept that I present to the entrepreneurs I mentor. It consists of a simple phrase that will implant a different idea in the mind of a potential buyer. As the character played by Leonardo DiCaprio says in the movie "Inception," an idea is the most resilient parasite. Once implanted in a brain, it is nearly impossible to eradicate. The IIP is the vehicle for implanting the idea in the brains of potential buyers of your company.

The ideal IIP should be specific to you, your company, and your interlocutor, but as a macro direction, the IIP could take a form like: