The urge to merge

Consolidation is rampant in the industrial distribution market, as eager buyers and sellers take advantage of the sector's popularity with private equity investors

By Brad Perriello, Associate Editor -- Industrial Distribution, 1/1/2007

Mergers and acquisitions in the industrial distribution sector are booming. As an example, look no further than British plumbing leviathan Wolseley plc , which spent more than $3 billion this year on acquisitions.

Or take the emergence of HD Supply, the Home Depot's wholesale distribution division, as an industry leader, accomplished by the purchase of a number of distributors in the United States and Canada.

No matter where you look in the sector, mergers and acquisitions abound and show no immediate signs of slowing down. Wall Street's favorable view of the industry, the large number of small companies on the market and a bevy of buyers with money to burn are spurring a welter of transactions.

Corey Whisner, director of investment banking for Credit Suisse Securities LLC , says the merger activity is being driven by a few factors, chiefly an abundance of willing buyers and sellers.

“Buyers are flush with cash, the [industrial distribution] business is doing well and Wall Street is rewarding growth and acquisitions. Buyers are feeling good and going out there and being aggressive,” Whisner says. “The distribution arena has become very popular in the private equity area—if you're a seller and you're thinking about selling the business, now is the time to sell because evaluations are so strong.”

Private equity investors' interest was piqued by recent successful IPOs, such as Interline Brands in early 2005, and the emergence of HD Supply as a major industry player, he says.

For distributors, being acquired by a private equity firm can provide a number of advantages.

That was the case for PRC Industrial Supply of Portland, Maine, which was purchased by private equity firm Singer Equities in July. Singer has been active in the rubber industry, buying several distributors.

PRC president Dick Hall says the deal made his company stronger in several ways.

“We wanted to have the access to more capital, access to more product lines and, overall, just a bigger footprint,” Hall says. “In all of the ways we could measure it, we felt it made us stronger in the marketplace.”

Whisner says larger players looking to increase their footprint are also driving the consolidation trend. He cites U.S. Electrical Services Inc.'s acquisition spree this year as an example—USESI bought seven smaller electrical distributors in 2006.

“You have a couple of the bigger players out there taking companies and trying to expand them geographically through acquisitions, for example U.S. Electrical,” Whisner says. “People are seeing other companies being sold at these big prices. If they have any inclination to sell, they're saying, 'Maybe I can get that [kind of sale price] too.”

According to Martin Bailey, general manager of INCOM Distribution Supply , an MRO distributors buying group based in Fort Wayne, Ind., there's another, often overlooked factor in the spate of mergers this year—family-owned companies that don't have adequate succession plans. That's because the second generation in family-owned businesses often has no interest in taking up the reins, he explains.

“You don't have people coming out of college today saying, 'Let's open a distributorship,'” Bailey says. “[Business owners'] kids go to college and come back and aren't interested in the business. Because of that, the owners are less likely to put together a succession plan. They get their name out there to sell and somebody picks them up. It's something that the industry needs to be talking about a little more.”

The rapid pace of acquisitions doesn't necessarily spell doom for smaller distributors, though mid-sized companies might have some trouble matching the big guys' economies of scale, Whisner says.

“There's always going to be a market for the small guys,” he says, citing their ability to provide strong customer service to a local niche market. For mid-sized distributors vying for their niche against national giants, however, the trend favors the larger players.

“Midsized [companies] trying to compete against larger guys that have infrastructure, scaling and sourcing advantages—being that kind of middle-size player is a tougher place to compete,” he says. “If you're trying to service a multi-location customer, the big guy is going to have an advantage.”

Don't tell that to Bill Weisberg, president of Affiliated Distributors , a wholesale buying and marketing group based in King of Prussia, Pa.

Weisberg says the heightened interest from the private equity sector is based on inflated profit figures from recent spikes in commodity prices, meaning investors may be riding for a fall.

“Private equity firms like to say that distribution is a safe and stable place to find solid earnings. But the truth of the matter is that distribution is a low-margin business, and it's only hot right now because a two-year growth in commodity prices has led to highly inflated earnings,” Weisberg writes in an e-mail. “There's a lot of money being spent on companies that will never provide an attractive return on that investment.”

That's due to the difference between the economies of scale available in distribution compared with manufacturing, he contends. While a manufacturer can realize economies of scale through size, in distribution the economies of scale are far smaller, Weisberg says.

“All the people who talk about creating economies of scale in distribution through acquisition, and uncovering waste and inefficiency in current operations to achieve a sustainable competitive advantage, are just theorizing about it,” Weisberg maintains. “The reality of distribution is that it just doesn't work that way in practice. Large distributors are simply not more efficient (or profitable) than smaller companies. Nor do they provide better service to customers.”

In the five industries Affiliated serves (electrical, HVAC, industrial, plumbing and PVF supply), Weisberg says when a national chain buys a local independent, other small distributors in that market gain market share.

“Customer dissatisfaction and employee dissatisfaction with the acquired company increases and local distributors gain,” he says. “Being national just provides more complexity and makes it harder to make the best local decisions. Independents beat nationals in their market because it just doesn't take much in the way of size for a distributor to get to the point where they are just as efficient as a large national player, and they are much more in tune with their local customers.”

Though he disagrees with Weisberg on the effect of consolidation on market share, INCOM's Bailey says smaller players can compete with bigger chains by focusing on providing superior customer service and value-added solutions.

“Industrial distributors continue to lose market share to the larger players, and their customer base continues to change and evolve with manufacturing moving offshore. Some small to medium-size companies are just going under,” Bailey says. “The ones that survive will be the ones that excel in customer service and providing ongoing value-added solutions to their customers.”

That's because large distributors focus on large end users, leaving local markets open for smaller players, he explains.

“I don't ever see the small industrial distributor going away. They provide a valuable role in the form of great response time, quick service, technical support and hands-on, face-to-face relationships that those big guys aren't going to provide for small or medium size accounts,” Bailey says. “I don't ever think you're going to see three or four major players and that's it.

“You're always going to have, in local markets, a need for local representation. There's a whole host of commercial industry users out there that desire local distribution, if the same products can be provided at the same price locally.”

Another market small and mid-size distributors can exploit is second-tier supply, Bailey says.

“If a company has an integrated supply contract with a distributor, that distributor is looking for a second or third-tier supplier for those procurement needs. In a lot of cases they're having to turn to local distribution. It can be a pretty lucrative business because typically you're able to hold a better margin in those situations,” he says.

And in cases where a company needs odd items quickly that their integrated supplier can't provide, often the company turns to a small, local distributor that can supply those items on short notice, Bailey adds.

Credit Suisse's Whisner believes the merger trend is likely to continue, fueled over the long term by the large number of small companies that serve a variety of markets in the sector and over the short term by distributors' strong performances.

“It's a very fragmented industry,” he says. “Since it's so fragmented, consolidation can go on for a long time. The particularly strong activity is being driven by the current strong performance of the industry.”

Affiliated Distributors' Weisberg agrees that there will always be some consolidation in distribution, but says the current rate of acquisitions is not sustainable.

“The current boom in consolidation activity will surely lead to an inevitable bust. The economics just aren't there to support continued investment at the rate we are now seeing.

“There are some companies out there already that hope they can do an IPO before the market changes or that some acquirer will come along and pay them an even more ridiculous figure to salvage their investment,” he says

“Sooner or later, and I would bet that it will be sooner, investors (and the market) will wake up and realize that distribution is just distribution.”