Merger mania

In an exclusive roundtable meeting, executives from the leading acquirers hint at what to expect down the road in a consolidating market

By John R. Johnson -- Industrial Distribution, 6/1/1999

Indeed, mergers are happening fast and furious in the industrial distribution sector. This year alone, five members of our Top 100 were purchased. Predictions are for that pace to increase in staggering fashion in the months to come.

Why the sudden rush to become bigger? Who are the major players? What do they look for in an acquisition candidate? In February, ID sat down with several of the leading acquirers to discuss these questions and more. Some startling comments resulted, and can be found on the following pages.

This is the first of a series of three articles that will address the consolidating marketplace. In July, results of a second roundtable discussion will focus on how consolidation is affecting relationships between manufacturers and distributors. Our third roundtable, appearing in August, will examine the issue of whether to remain independent or sell out.

The event was co-sponsored by Industrial Distribution magazine and Brown Brothers Harriman, a New York-based financial institution with revenues of more than $500 million. Its mergers and acquisitions group specializes in transactions ranging from $10 million to $1 billion, generally advising private and closely-held public companies on financial and strategic issues, including mergers and sales.

What are the forces driving consolidation, and why is it taking place?

PINSON: "It's a pretty compelling equation, if you believe that our customers are spending 80 percent of their procurement dollars buying the category that we all distribute. So, there's an enormous opportunity, obviously, to save costs. Customers are driving consolidation. They're looking for single-source vending, they're looking to outsource a lot of the services that they have been providing very expensively, internally.

"Certainly, for the larger companies, you need the ability to support them at multiple sights and multiple locations, in multiple commodity classes as well. So, I really believe very firmly that this thing is really all being done at the instigation of our customers."

THOMPSON: "Consolidation goes through cycles. There's certain things that trigger it, either a soft economy or eroding margins that require you to do different things to lower your costs, so you can be more profitable. The U.S. had some major consolidation in the electrical industry in the early '80's, because they saw margin erosion first. Later, you saw drug companies [consolidate]. And most of those consolidations were created by margin softness in their industries, and they had to find ways to consolidate to lower the costs of staying in business.

"So, I think it's triggered very often by margins in tough economies. And tough economies create very few price increases. You just have to look north to our Canadian neighbors. They consolidated a decade ahead of us. If you look at the giants in their markets, they have 20 and 30 percent market shares in industries that our guys have five percent shares in. So, we're not ahead of the curve on consolidation. We've just had better economies that prevented us from having to do it.

"The dynamic that's occurred in the last couple of years is that there's so much success and money. Businesses made so much profit, that the seller now realizes maybe they can get a lot of money for the business, and they're choosing to sell."

BALDWIN: "I think it's going to continue because of the economics that the consolidators will bring. All of a sudden, we have buying leverage with our suppliers, and that will make us more competitive against the local competitors that don't have that same buying power. In addition, consolidators have the ability to spread fixed administrative [costs] over a larger sales base, and their SG&A as a percent of sales will be less."

Where are we at this stage? Have we just touched the surface? Have we reached the mid-way point?

SYDNOR: "If it's a ball game, I think we're in the second inning."

PINSON: "If you look at other industries that consolidated, they tend not to consolidate to the 70, 80, 90 percent rate. So, if this industry follows a similar pattern, we'll consolidate to the 40 to 60 percent range, which would be a very aggressive number. So, that would leave 40 percent of the existing players in place."

What does this mean for the future? Do you see a bunch of $10 billion players, with niche players cutting out a portion of the market?

SYDNOR: "The [life span] of the independent distributor will be a lot shorter than it has been traditionally. There will always be a place for the small application-oriented distributors. But instead of going through three, four or five generations, the independent niche oriented distributor will probably survive one generation, to where it will evolve into something else. It will find its place in the sun and quickly move on. You're probably looking at a life span of 25 or 30 years, rather than the traditional 75 or 100, or whatever it may be."

JACOBSON: "I think unquestionably, an aggressive, fast-on-the-feet, small or mid-sized distributor has tremendous advantage over companies like ourselves, whether it's from technical expertise or being very plugged into a particular customer, and really understanding the processes of that customer and having the ability to add value. This can, where necessary, form the alliances to service the customer, and almost embed themselves in the customer's process."

What will the industry look like in five years?

BISHOP: "I think it will look a lot like the electrical wholesaler market today. There are about eight electrical wholesalers today at over $1 billion in sales. Five years from now, Cameron & Barkley's plan is to exceed $2 billion in sales. We have about $800 million this year [in 1999]. And about half of that growth will be organic. Our historical growth has been about 65 percent organic.

"But acquisitions will play more of an important role in our future as we become more national in scope. In five years, industrial distribution will look a lot like electrical distribution does today, in that you have 10 to 12 or more distributors with sales in the billions. There are several that are well on their way to that now.

"In terms of the smaller distributors, those folks have a home. I think they have a future. One of the keys is the alliance -- to align themselves with the integrators that are new to our industry or that are outside our industry."

PINSON: "I've already been quoted in your magazine (August, 1998) -- at about [$20 billion in revenue in the future], as I remember the number. I clearly think there's an opportunity to build companies of that size. They'll be in multiple commodity distribution, they'll be in multiple geographies, and in multiple channels.

"So, my own vision is a company that will be multi-billion [in revenues], will be in several commodity categories, certainly will be worldwide as well as domestic, and will have multiple channels of distribution. So, I think the distributor in the next five or 10 years certainly has to address all of those issues, in terms of having them indebted by their strategic plan."

Is there a particular size distributor that is more desirable for a sale than others?

SYDNOR: "If you can do it on a handshake, you can do the $2.5 to $3 million [deal]. But if you have to go through the whole process, including the investment banking advisors, the battery of lawyers and accountants, you can do a $40 million deal for what it costs to do a $3 million deal. Whatever your own particular cost factor may be, whether it's $20 million, or the $30-$35 million range, there are certain minimum values you've got to get a return on for the effort expended both in just manpower, as well as monetary dollars."

PINSON: "Well, our pattern, as we've explained is really a hub and spoke pattern. A hub company is primarily driven by needs for geographic coverage. Those companies tend to be the $20 to $25 million dollar size -- hopefully larger. There aren't too many that are much larger than that.

"The spoke acquisitions are acquired for a whole variety of reasons -- either product line alignment, coverage to a particular customer, further penetration, or elimination of competition in that marketplace. There are a whole variety of good and justifiable business reasons to do an acquisition. And, in that case, the size is relatively irrelevant. Three-million and $5 million acquisitions are just fine. If you have an infrastructure in place you can do a $3 and $5 million dollar acquisition relatively efficiently. Although, George is exactly right. On a per dollar basis, it's more expensive than a larger acquisition."

COWIE: "Transaction costs are pretty high nowadays. You can go out and do 10, $3 million dollar acquisitions and spend a hell of a lot of money that doesn't add to your bottom line -- in fact, it takes from your bottom line -- or do one $40 million deal that may, in terms of financial purposes, look better. But, it could be the little $3-$5 million deals that bring you some particular technical expertise or a knowledge base that moves you toward solution selling. The size is important to a degree, but if there's a value there, then it's worth looking at almost regardless of the size."

JACOBSON: "We're very specific in what we're looking for. Although we have very specific targets that fit in to the business strategy, we all look outside of those, I would guess, to look for new platforms for growth. We're extremely growth oriented. It's just a mantra within our company. So, buying something that's in a decline -- unless we can really bring something to the table -- doesn't interest us."

What are the criteria of an attractive acquisition candidate?

PINSON: "Clearly, we're looking for companies that go to market, leading with their technical expertise in cutting tools and abrasives. Because we have some geography to cover, we're looking for companies that cover regions that are still key to us, and we have a lot of markets still to cover.

"We're looking for companies that have a discipline to profitability and who are probably better operators in terms of profitability than are existing companies."

THOMPSON: "What we're looking for is companies that are in the service industries to protect people through the services, and through the knowledge base inside the business. But we also look at product companies that go in geographical voids, or somebody that has some strength in the market that can add value to us and bring us something that would be accretive to the balance sheet and to the earnings. We are also very interested in the multi-national partners."

BALDWIN: "Obviously, our heritage is fasteners, so we're looking for companies that have a fastener heritage, and are focused on providing a variety of inventory management services to the OEM. We truly believe the future is more in providing the services than in merely having the inventory on hand.

"Another screening factor we use is the companies' past track record. We do not look for turnarounds. We want those companies that have outperformed the competitors, in terms of internal growth and margins."

JACOBSON: "On the branch base side, we're looking very similar to the areas that Marty is looking in -- in traditional mill supplies, cutting tools and abrasives. In that arena, we're looking for solidly managed businesses -- good solid growth and management continuity. We're not in the turnaround business.

"The second type of acquisition we look at is catalogs. And there we are comfortable with turnaround situations. We've bought some that are profitable, and some that aren't. The third type of acquisition we look at is platform -- either a new customer set or a new product line that will really materially alter and improve the way that MSC currently functions."

BISHOP: "We're looking for the high quality distributor. Size-wise, that can be anything from $5 million to $50 million. We can talk to the guys that do a couple hundred million, too. We're looking at industrial, electrical, electronic, safety, and power transmission to support our mission of providing a total MRO solution that our customers are asking us to provide.

"We're trying to provide as much of the market basket as we can. We do tuck-in's also, where it makes sense. And those are some of the most rewarding. We did several of those in '96 that are nice little success stories. Critical mass, though, is pretty broad; $5 to $50 million probably covers 80 percent of the candidates that we would see."

COWIE: "I think there are always opportunities for a tuck-in, either in a particular market, or in a particular industry. Maybe somebody that's found a particular niche and does something well that you think might add some value.

"We're clearly not interested in turnarounds. But, I would like to believe we would get to a point where we would feel confident enough to take on somebody that's struggling."

How do you sell yourselves to the companies you bid to acquire?

PINSON: "The strengths of IDG largely rest on the fact that we use a decentralized approach -- we're looking for the entrepreneur who wants to remain active in his business, is looking for the initial resources that we provide, still has a lot of energy, and wants to continue to build his business. That's what we bring to the table that distinguishes us from other companies. We leave the name on the door, we leave the management team in place."

THOMPSON: "Discussing situations with the seller is the core competency of the businesses that they are looking at, and who fits their core competency and provides the most synergistic effects that will keep the business they developed intact and move forward so that they can be proud in their community with what they accomplished. Their name may remain on the door, it may not remain on the door, but certainly their image in the community is still there and they want to maintain that very highly.

"They like the chemistry of the trust between the buyer and the seller, and they're going to choose somebody that they feel comfortable with."

BALDWIN: "We also have a decentralized structure but that's not what I call a differentiator because some of our competitors have that same orientation. I think the differentiation that has really made us an acquirer of choice is we are owned and run by people that have grown up in this industry. Five of our nine board of directors are former owners, and that provides a lot of comfort to the people ... that this is a fastener group. In addition, several of the people on our board have held trade association positions in the past, so they are recognized in the industry."

JACOBSON: "We offer quality local distributors enormous capabilities. First is our culture. We are growth minded and people oriented, and have a very exciting work environment. Second most important is our leadership. We are run by distribution people who grew up in the business. My father, who founded the company, is still active. I began with MSC in 1976 when our revenues were in the $5 million range. I grew up in an entrepreneurial environment and have not lost that feeling and love for the business.

"Numerous senior managers at MSC grew up in local family-held distribution businesses. Third, we have done a terrific job of retaining and motivating those who have sold us their companies. Finally, a seller can be confident that his or her associates will have exciting career opportunities with one of the clear survivors in this industry."

BISHOP: "At the end of the day, we expect to pay fair value, and I would expect if there's a competitive situation, we all approach value very similarly, so we differentiate ourselves on culture. For the entrepreneur who wants to continue in business, we're selling wealth creation. We can pay you fair value today for what you have created, and you will participate as an owner in our business via our ESOP. We've got one shareholder, and it's the ESOP -- and you will participate in it, and then all your employees will now be employee owners. So, we're selling wealth creation. It's not a lot different than the way Wall Street works. Our stocks are valued once a year, not every second, but everything is driven towards what does it take to increase value, all the way down to our newest truck driver. That differentiates us many times to some entrepreneurs."

COWIE: "Trying to develop a unique set of solutions for the market is something that we would attempt to share with a seller and certainly the wealth or value creation. We don't have all of the same weapons or tools available to us that the public folks around the table do -- maybe a little bit more in the venue that Randy's talked about. But certainly, one of the longer term or medium or longer term strategies is possibly going public or possibly looking at something that would allow additional value."

As acquirers, how would you advise distributors preparing to sell his or her company?

JACOBSON: "View the company as a product; position it and plan the sale. Look at the features and benefits that you have. What's strong about the company? Is it a particular system or particular product capability?

COWIE: "It really is no different than approaching a big customer prospect. If the distributor has to sit down and do a whole lot different than what they've been doing every day, then they're either trying to come up with a charade, or they're trying to market something that really isn't there. It ought to be not much more than selling what they would sell a customer every day, only selling it in its entirety to a slightly different type of buyer."

THOMPSON: "They should certainly tweak your interest by giving you at least a couple of years of their financial statements to let you know how they've been doing historically and whether they're growing, and what type of value they add to the business. We'd hope they'd be audited, because that's obviously a concern.

"I think they have to decide what their family planning estate and personal goals are. Too often they haven't made that decision. You find that very often if you're approaching them. And that's one of the roadblocks -- they haven't decided what they really want to do.

"If you advertise the sale of your business, you're likely to lose a lot of your people, especially if you're a small business. And that's the biggest thing I would guard against, is letting it leak by bringing too many people in the loop. More often than not, once it leaks, the small competitors in the market start reacting. When that happens, the value of the business does change."

BALDWIN: "We always advise targets to make sure they have a trusted advisor, experienced in mergers and acquisitions. Trusted in the sense that when he tells you something, you don't question it.

"So, we believe both the buyer and the seller benefit if the seller has an advisor who's experienced in mergers."

How do you value a firm?

JACOBSON: "I think it's very similar to the way Wall Street values earnings -- the more predictable the revenues are from the company, the less of a haircut they get on the cash flow. So, at the end of the day, if we walk in and did the numerical analysis and it really feels good to us, we take less of a discount. And if it doesn't feel quite as good, we're going to discount that cash flow a little bit more heavily."

BALDWIN: "I think you're always going to discount the projected cash flow. How much you choose to discount it is a direct function of the risk inherent in the projection, which is quite subjective."

SYDNOR: "The quantification of the qualifying factors is more in the eye of the buyer -- as far as he says how that might benefit his company and his process. And the seller may be totally unaware of that if he has not properly prepared himself, to say, "Hey, this is what I'm really good at." The hype will really benefit you, and it's not in these numbers, but it's a qualification. So, putting a quantification on a qualification sometimes makes or breaks a deal."

PINSON: "I don't want to be controversial about this, but I've got to tell you that I'm as seduced by solid management teams as all the qualifications we're talking about. But, the theory is that all of that should show up in the numbers. We've all seen A management teams with B financial results and visa versa. And I just always have to pull myself back and say, 'it really ought to be showing up in the numbers.'"

Are valuations of distributorships still sky high?

SYDNOR: "Quite often, the seller has got so much value tied to the emotion that he can't differentiate the real value versus the emotional value. I don't think that you can let [multiples] get in the way of good common business sense as far as what you're willing to pay. And I think in this game that you can't overpay."

PINSON: "We've all done enough deals that the proof is in the pudding. In fact, there are enough price expectations that have been met ... My suspicion is that it's sort of a bell-shaped curve. As long as we're all playing in the high part of the curve, deals will get done and there will be people that fall off on both sides because of price expectations. That certainly has been my experience."

BISHOP: "I actually saw more deals not get done in '97 versus '98, because buyers' expectations were so extreme that we couldn't get the win-win. We didn't announce any deals in '97, but we looked at more deals and did more work in M&A in '97 than we did in '98, and didn't have much to show for it."

COWIE: "A couple of years ago, there might have been more appetite to pay a little premium for a platform business, but now, the consolidation process has moved along enough that to pay a premium today might only put a set of shackles on you and a big lead ball you got to drag around with you."

Talk a little bit about the structure of a transaction and the financing of a deal.

PINSON: "We've been all over the lot, obviously. And we were largely oriented toward equity based transactions early on, when the stock was higher. And so, obviously, as the stock has fallen, in our case, it's no longer currency for transactions -- [so] we switched to all cash.

"We have seen a lot of valuation based on the model of 'what we can do with them.' And, I think there's a risk in that because it really depends on having a relatively mature system that you can count on making those changes. In other words, you're taking the revenue of the target company, and you're putting it into your system and saying, "In our system, it will generate X percent." If you don't have a relatively mature company or system that you can count on making those differences, you run the risk of being disappointed in those results.

"On the issue of earn-outs, I am a believer that earn-outs, in fact, do work. And, I think you have to be relatively creative about them. There is more reluctance in this industry to doing earn outs than I have seen in other industries. A couple of possible explanations would be that our industry is coming off of a very high high, and I think that's a significant fact -- that people don't have the same confidence in the future that they've had in their past performance. And I think also there's an inherent conservatism in this industry that makes those people reluctant to commit to performance in the future. But I believe that creatively constructed earn-outs work very well if you identify the factors that carry-over management will be responsible for."

SYDNOR: "These people have all been entrepreneurial types and taken what they wanted out of the business, and all of a sudden you tell them that to get their perceived emotional value out of the business, they need to take an earn out. And they recognize that you're calling the shots, and they're not. And how can they trust what the earnings may be in the future? It may be beyond their control. And so, they have an inherent distrust as far as earnings are concerned and say, 'No, I'm not going to do that.'"

PINSON: "Two answers to that. One is that if you're putting several million in the guy's jeans, he can afford to step back in terms of what he takes out of the company because you capitalized the money he's been taking out. Number two, as I indicated before, you've got to find the thing that he can be responsible for that isn't a function of the integration. And it could be that he's got an existing customer list and you can certainly identify those customers. And it could be the sales carry over and gross margin carry over for those customers. That would still be within his control, no matter what I do to integrate the back office. But, if he's delivering the gross margin, that's what we've contracted for. That's what he's promised. That could be the basis for the earn-out."

COWIE: "So long as it's a competitive environment, it's just like a sports team. I've never understood why -- it doesn't matter whether it's baseball or basketball or football -- these guys will pay guaranteed salaries, and you look at guys sitting on a bench that are making $6 or $8 million dollars, and they won't play a second of a game because they're injured.

"There's no performance clause to their contract. But, so long as there's a few owners that don't care about that -- and I'm not saying that that's this group -- I think sellers may believe they can continue to stonewall an earn-out type process, because they'll find somebody that will give them a deal that doesn't involve that. In a perfect world, I'd rather have an earn-out because I think it gives you a hell of a lot more comfort that [sellers] are going to do their best to make sure that whatever they've sold you is going to really happen."

THE PLAYERS

MITCH JACOBSON

President

MSC Industrial Supply

MSC was founded in 1941, and was a $5 million business when Jacobsen came on board in 1976. Today, the firm has 1998 sales of $583 million.

MARK BALDWIN

Chairman & CEO

Pentacon

A fastener rollup, Pentacon went public in March of 1998 and has made four acquisitions. The firm expects 1999 revenues just shy of $300 million.

TED COWIE

Executive VP & COO

The McGraw Group, Inc.

The McGraw Group is a holding company with industrial sales of $82 million.

MARTY PINSON

Former Chairman

Industrial Dist. Group

IDG was formed in 1997 by the rollup of nine industrial distributors, and went public in Sept. of 1997. The firm has revenues approaching $600 million in 1999.

GEORGE SYDNOR

V. Chairman, Bus. Dpmt.

The McGraw Group, Inc.

The McGraw Group is a holding company with industrial sales of $82 million.

JIM THOMPSON

President & CEO

Vallen Corp.

Vallen is concentrating on consolidating the safety business and services. The firm has 1998 revenues of $364 million.

RANDY BISHOP

CFO

Cameron & Barkley

Cameron & Barkley is 100 percent employee owned and has grown from $29 million in revenues in 1975, to having sales of $613 million in 1998.

IDG still searching for Pinson replacement

As Industrial Distribution went to press, IDG was still searching for a replacement for chairman Marty Pinson, who resigned from the firm two weeks after participating in this roundtable event. Pinson's comments in this article reflect his opinions on the consolidation market from IDG's point of view.