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The wholesale distribution acquisition scene: Will history repeat itself?

by Scott Benfield

The first decade of the new millennium was subject to business excesses of record proportion. A microcosm of these excesses was in the mergers and acquisitions scene in the Wholesale Distribution sector of the economy. Whether the buzz word is acquisitions, accretive growth, or consolidation, the combination of speculative investment, inexpensive debt and unlimited borrowing fueled an acquisitive boom. Today, the first month of the second year of the second decade of the new millennium, we can look at the activities of the recent past and, hopefully, learn some important lessons on what works in acquisitions and what doesn't.

A sector ripe for consolidation
Consolidation, the buyout of smaller firms by larger ones, is still a reality in the fractious markets of B2B distribution. The dynamics of many small and medium-sized firms, third- and fourth-generation private management, and numerous family shareholders with differing agendas makes the acquisition scene vibrant. In addition, distribution is a diversified business covering many sectors and serving many small accounts; in essence it is a stable business and it is difficult to foul up.

Because of these dynamics, we forecast significant acquisition in the next decade, albeit with some notable changes and, hopefully, some lessons learned from history. Prominent in the next decade will be the rise of super-regional firms in most every sector of the some four dozen vertical product markets of B2B distribution. By super-regional, we mean large $100 million-plus firms that dominate a region or regions of the North American economy. An example is the electrical/industrial firm that dominates the Northeast and Mid-Atlantic regions with sales approaching $350 million. Super-regional firms and regional firms ($25 million to $100 million) post the greatest potential for the acquisition scene both in potential reward and risk. There are a significant amount of these firms, in all sectors, that will be both acquirers and candidates for acquisition.

The challenge and risk/reward is borne by the acquiring firms; the stakes have never been higher and are primarily due to the size of potential deals. In decades past, acquiring $5 million and $10 million firms, while challenging, was not all that difficult because of their size and they could be, more or less, easily absorbed. Today, however, the firms up for sale have often grown by acquisition and the current shareholders want out. The buyers are larger firms, the regional and super-regional companies, and we believe that there will be many who will struggle with acquisitions because they haven't learned the lessons of recent history.

The players and their roles
Hardly a fortnight goes by without our office receiving some hype from a business broker, private equity firm, or wholesaler-gone-mad reciting the opportunities of selling the wholesale firm. For brokers and private equity firms, their business models depend on the buying and selling of businesses. Without these activities, there simply is no reason for their existence. Brokers especially have little interest, despite their protestations to the contrary, in the long-term success of the transaction. Their value added is marketing, negotiation, valuation and putting the parties together. Business brokers typically charge 6% to 10% of the deal's value, which seems exorbitant but we've met some worth their salt. Brokers run the gamut, however, and there are few standards for their profession, with some states requiring only a licensing fee. But brokers aren't around for the post-acquisition absorption of the business and, as such, don't influence the structure of the industries they deal with. On the whole, brokers are catalysts for the acquisitive process, but not players in the post-acquisition issues. Therefore, while worth mentioning, we can't label them as a positive or negative influence on consolidation.

Private equity firms are the 1980s version of leveraged buyout firms. They are financial buyers who assemble equity and mostly debt financing to buy firms. There have been, in the past decade, numerous private equity deals in distribution. We've had several firms as clients. Private equity, when it works well, hires experienced board members who know the distribution landscape, especially from the operations side, and who spend considerable time advising the portfolio companies. When it works badly, private equity firms strip out service costs, leverage up on debt, take out growing management fees, and flip the firm before it or the market crashes. There have been numerous studies on the value added by private equity firms and many of the conclusions are not flattering. We've been tough on the "strip and flip" variety and our experience is that, in high growth business cycles, some two-thirds of the private equity deals are of this type. But we don't forecast the same heated competition for private equity deals, evident in the last decade, in the coming decade. Why? The growth dynamics, cost of capital and lending environment won't support as many of the "strip and flip" variety deals. We look for the cost of capital to rise, albeit slowly. Mostly, however, there won't be runaway GDP growth that allows for deal makers to time the "flip." There will still be private equity deals in distribution but the volume will likely be much lower than in the first decade of the New Millennium.

Distribution firm buyers are strategic buyers. They buy businesses that, hopefully, fit into and add to their business model. We see regional and super-regional firms as strategic buyers who will greatly influence the next decade. Too often, strategic buyers become enamored with the deal and the accounting profits of combining their firms. Accounting profit projections, however, are poor metrics by which to judge the long-term return of an acquisition. First, accounting profits aren't cash flows and our rule is that acquisitions should be judged by cash flows and their return on deployed capital and not share prices, P/E ratios, or pro-forma analyses. Secondly, there are many different types of acquisitions and these can have significant bearing on the financial outcome of the deal.

We spend the rest of this article in exploring what doesn't work well and what does work well in the differing types of acquisitions. It is important to note that our work in acquisitions is in helping both buyers and sellers of businesses over the past 10 years. Given the different type of deals, industries and strategic dynamics, empirical analysis yields poor results on identifying which deals have a greater chance of success. Therefore, we'll rely on experience for the rest of this article.

What doesn't work well in acquisitions in wholesale distribution

We decided to start with the negative portion of the acquisitive landscape and identify types of acquisitions that don't work well. We number them in no particular order.

1. Roll ups are the literal rolling up of firms typically in an industry or related industries. There have been substantial rollups in many sectors of B2B distribution and most, during a down cycle, have failed miserably. Rollups are like the manufacturing conglomerates of yesteryear. They promise great things with their size but, since their market focus is all over the place, they have difficulty generating new value streams. Rollups work only when the business cycle is booming and financing is easy and cheap, otherwise the strategy is flawed. Roll up denizens and their strategic reasoning is too often spurious and we visit the faulty logic in Nos. 2 and 3. In the end, the rollup is a PacMan strategy where the gluttonous appetite for acquisitions usually ends up where the proverbial "pigs get slaughtered."
   
   
2. Market share is a rollup reason espoused by several of the failed aforementioned companies. In essence, a distributor that rolls up significant share of market wins. The problem is that market share is a competitive factor only when two or three firms dominate. Growing share of market in distribution, where there are thousands of firms, has no strategic advantage and really can't be done as markets are fractious. Maybe, in 100 years, there will be two or three distribution firms dominating 90% or more of a vertical industry but we doubt it.
   
   
3. Cost advantage is cited as a reason by rollup artists and other acquirers in distribution. But you can't leverage costs all that well in distribution to get a competitive advantage. Our experience is that distribution, as a business model, doesn't scale well. Why? Most of the discretionary and actionable costs are service based and they are aggressive step costs that closely track sales. In other words, you can't leverage fixed costs in distribution because operating costs aren't fixed.
   
   Another cost advantage is espoused to be an advantage on the buy side. In essence, a distributor that buys more has a buy side advantage but there are two flaws to this argument. First, with globalization of supply, there are now dozens of manufacturers, around the globe, from where to source goods. Hence large distribution firms can't corner the supply side on much of anything. Second, most distributors, who aren't mega-sized, are members of buying groups that pool orders and buy at discounts similar to large companies. Ergo, supply side cost arguments for distributors is a poor logic.
   
   
4. Buy low is an acquisitive strategy of paying as little as possible for the acquisition. At some point, in buying a business, you get what you pay for and more than you bargain for. In essence, if you buy the least expensive company on the block, you get a bunch of problems that cost significant time and effort for executives and managers of the acquiring firm to fix. In one example, we know of an electrical distributor who purchased a firm on the ropes and roughly of equal size. Several years after the acquisition, most of the employees of the acquired firm had left and several key members of the acquiring firm were burnt out and exited also. The acquiring firm went through several embarrassing years of losing money or making vapor profits. Only recently, our sources tell us, is the company back on track, and this is many years after the fated acquisition. In another example, an equity firm purchased a distributor that had been through several hands and was losing money. Three years after the acquisition, the equity firm had the portfolio company file for bankruptcy protection.

What works well in acquisitions in wholesale distribution

1. Running the firm better with better execs and managers. Where the acquiring firm has demonstrably better execs, managers and processes, there is often a successful acquisition. If you are wondering if your wholesale firm has better execs, managers and processes, look at your earnings. Most wholesalers average 2% to 2.5% of sales, as earnings, before taxes. This is not stellar performance. We typically find these firms that acquire companies get into trouble. Good distributors run at 3%, and more likely, 4% or more of sales in pretax income. If your profits are poor, then it is often a reflection of execs, managers, and processes that are not in the best of shape. It's hard to add value to an acquisition when you can't keep your own shop in the best of order.
2. Reduction in capacity. Many distribution industries are mature with limited or flagging growth prospects. Hence there are often opportunities for capacity reduction. Companies that can reduce bricks and mortar often do well in distribution acquisitions but fixed assets are typically low in distribution and capacity reduction also needs to take place in the reduction of sellers, branch managers, and support staff. If the acquiring firm can substantially reduce the headcount, absorb needed services at HQ, and keep service levels seamless and high, then there is good reason to believe the acquisition will be successful. If you can't find where you can reduce fixed costs of bricks and mortar and substantially reduce headcount in both back-office and sales functions, then don't do the acquisition. 
3. Give market access to a smaller company with a great service or product. Often, small companies have a unique service or product but are under-marketed. If an acquiring firm can offer a small company access to a much larger market, the acquisition is often successful. We've witnessed distribution firms who acquire both unique product and service firms, offer them access to a larger market, and profit handsomely from the acquisition. The acquired service or product should fit into the current industry, have a visible advantage, and be relatively easy to sell including a short sales cycle. Too often we've seen distributors buy complex product firms with highly technical products with long sales cycles. They often become disenchanted with the acquisition. If the service or product is nichy with a high cost of labor and downstream high-touch service needs, you might want to pass.

"Duh" factors in Acquisition
We haven't included factors such as industry experience, common vendors, and common served markets in the factors for successful acquisitions. To us they are obvious and our response is Duh! However, we do find firms that acquire companies in which they have no experience in products, markets or services and don't know the industry. When this happens, the cultures clash and the acquiring firm, by dent of size, forces their views and processes on the acquired firm and the acquisition loses. We recently interviewed a medical products firm that sold to large corporations with unique inventory services and a high level of customized services. The acquiring company sold medical products also but the products were their only commonality. The acquiring company was a mass seller with no respect for and understanding of customized services, longstanding relationships, and a high-touch environment. The bottom line on the acquisition was that the acquired company was having problems in maintaining a customized bevy of products and services. They were being overwhelmed by the one-size-fits-all culture of the parent company and their customers were leaving because of poor service levels.

You gotta have the players
In summation, we see substantial acquisitions in the distribution sector and by strategic buyers in the coming decade. Other acquirers, including private equity firms, will be less visible than they have been in the past. One major hurdle awaits the regional and super-regional buyers and that is having the correct players. Often, a sizable acquisition can make even a well-run firm an also-ran. As companies grow, they often outgrow the players who got them to where they are. Hence, the adage that "those that get you where you are aren't necessarily those who will get you where you need to be" warrants attention.

Many regional and super-regional distributors are managed by successful businessmen and philosophies that came out of a high-growth environment where products and services were less commoditized than they are today. Many came up through the sales ranks or branch manager ranks and don't have exposure to running a large firm. We know of several companies that acquired their way into sizable entities only to find that their managers and execs can't handle the demands of running a large company. They don't understand the planning, follow up, analysis, and communication needs of running a large firm. Hence, we expect many regional firms to acquire their way into trouble by dismissing the complexities of size and scope. Those companies that anticipate these issues and hire managers who have a record of dealing with large firms and complexity will win.

Scott Benfield is a consultant for industrial channels based in Chicago. Scott is the author of five books and numerous articles for distributors. He has 20 years of managerial and executive experience in Fortune rated and nationally ranked B2B firms before establishing his consulting career. In the past decade, he has consulted for some of North America's leading firms on a variety of issues. He can be reached at bnfldgp@aol.com or (630) 428-9311. His firm's Web site is www.benfieldconsulting.com.

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