What makes one electrical distributor worth more than another to a prospective acquirer? We sat down with some of the industry's most active consolidation executives and asked. Here's what they said. (Second of two parts.)
The electrical wholesaling industry may or may not be consolidating on a large scale, depending on how you look at it, but clearly there are a lot of mergers and acquisitions taking place. What's driving the companies buying up all these distributorships, and what are they looking for in an acquisition prospect? We asked top executives of some of the most active acquirers in the industry today to give us their thoughts over lunch.
In the second part of the roundtable discussion Electrical Wholesaling set up last November in conjunction with the merger and acquisition team from Brown Brothers Harriman & Co., the participants discussed the effects a number of factors have on the value they're willing to assign a prospective acquisition, and what sorts of obstacles stand in the way of closing a deal. They also talked about their individual companies, and why a seller should consider forming a partnership with them. So return with us now to Brown Brothers Harriman & Co.'s dining room at 39 Wall Street in New York City, where we pick up the conversation, already in progress...
(To read the first part of the conversation, see EW Jan. 99, page 24.)
Electrical Wholesaling moderator: How does information technology affect an acquisition? For instance, if one of our readers is thinking about selling his company and is facing an investment in information technology, is there any point in his going ahead with that investment if he's thinking about selling out?
Tom Formolo: From our point of view it's as much a nuisance as a benefit in an acquisition because one of the things we're trying to leverage as we grow is our information technology. To the extent that a large investment's been made by a company with which we're endeavoring to merge, value has been wasted, because ultimately we'll have one system going forward. That's an aspect of consolidation that's attractive-having all of your inventories and all of your customer data on one system, and managing the business as a whole in that way.
Ultimately, you have to select one system. Either you scrap the one you have, or the one that's in the acquired company gets scrapped.
Rick McClure: It's certainly easier, at least from our perspective, to do it when they're at that decision point. They're progressive enough to understand they need it, but they haven't invested yet. It makes it easier.
Steve Zepf: Well, we're supporting 22 systems right now. So, what's another one?
Moderator: I didn't think there were that many.
Zepf: I didn't either, but every time we do a deal we seem to find another one. So that's a major growth opportunity for us in terms of bottom line. Our goal is not to get everybody onto one system, because in our case that's not practical. There are differences in the customer base and information services that you have to provide for certain groups of customers in one product group that you don't provide for in others. In certain industries you're serving a dealer base. In others it's the contractor, utility or industrial customers, and they all have differences that affect the systems.
We're trying to take it from 22 down to two or three systems that we will support on an ongoing basis. And then we can offer a new company that comes in to become one of our partners an opportunity to pick any one of those two or three.
Our issue was that the hardware that we had in place just wasn't capable of supporting any more growth. We've gone from $500 million in sales four years ago to $2.5 billion this year. Our hardware up until now has been unable to support it. So we transitioned over to an HP-based system that hopefully, they tell us, is unlimited by virtue of its scalability.
In terms of looking at companies, we think there's probably going to have to be some sort of cutoff this year because of the Y2K issue. If we get up to June or July and we're looking at a company that's got a big Y2K issue, it's too late to do anything about it for the most part.
I'm not sure a lot of people realize how much is yet to be done out there, particularly some of the smaller to medium-sized companies using a standard (software) package that was offered by a company that isn't around anymore. Or maybe that particular software company isn't going to support a Y2K solution. Our biggest IT project this year is the conversion of all those systems.
Norm Brown: Information technology is something I know a lot of distributors are looking at. It might be Y2K-driven or just technology-driven, or driven by some of the products that are being developed. We're still a changing company ourselves, and we aren't under one computer system either. We're still operating on three systems inside our own company, though we're looking to change that environment.
We're looking for that to be a two-way street. Rather than tell them, 'Here's the way it is,' be it information technology, marketing or any of those issues, we're looking to create a two-way street rather than a one-way street. We would welcome somebody in information technology with expertise in that field.
Zepf: That's one of the things that we have found also in these 22 different systems. There are some great ideas in some of these systems that we want to try and incorporate into the two or three that we're going to support on an ongoing basis. And that's part of the reason why we haven't done some of them-because we're trying to do the programming that's required to incorporate some of these ideas. There's not been one acquisition we've done that we haven't found at least one good idea in information technology or marketing or inventory control. These guys were successful businessmen on their own, and they got there by being innovative. So we really don't want to mess with something that's successful. In fact, we want to take those ideas and spread them out over the rest of the organization.
Roy Haley: Your question was, what would you advise firms that are considering investing in systems. To put that in a larger context, I think he who hesitates is lost. Or maybe "is last" is another way of saying that. I don't think distributors can take the chance that if they wait they won't have to make those investments. I think everyone would be advised to try to be as good as they can be, to continue to develop these capabilities.
Systems is just one of those issues. If you look at capital spending, the two biggest areas of capital expenditure for us, maybe the top three, would be information technology, which is clear-cut number one. Facilities upgrades and expansions would be number two. Training is number three. Growing firms of small and medium size have to deal with all of those issues.
We don't want to buy a business that has grossly under-invested in any of those areas because it takes remedial action and effectively raises the price. Or, if you look at it another way, the business is less productive than it may at first appear. So shortfalls in investment programs of almost any type can affect the value that the companies can provide or create. If you look at it negatively, they've not been willing to make those kinds of commitments.
We, like others, are moving in the general direction of a single system. But when you have a system that's been developed and had features and capabilities added to it over time, it begins to be a customized system. And it is one of a kind, and there is nobody else on that system. So over time, we begin to migrate the companies that we've acquired onto a single system. We've done a lot of that. We still have some that are not on that single system, in part because of the timing of acquisitions and the appropriate timing of conversion.
Of course, the Y2K issue has sort of interrupted the schedule because we're putting more emphasis on being sure we're ready in that regard. And we will be using that also as a catalyst for further consolidation of our systems.
Formolo: I think there's one aspect that should be touched on in the context of systems, and that is the type of company you're talking about. If you're talking about a five- or ten- or fifteen-million-dollar-revenue company, you get, I think, one answer, which is the one that was provided earlier by me. And if you're talking about a $100-million to $200-million enterprise, you would get a second answer, which I think is more along the lines of what Roy said.
As Roy said, you've got to be investing in marketing programs and doing other things to grow your business. It's absolutely true. There's a positive relationship between growth rate and value. Another important aspect is sophistication of management. What firms like ours try to do is put those pieces of the puzzle into place so that along the way we'll experience growth in our valuation multiple. Certainly, as an independent business owner, to the extent you can put those pieces in place over the course of time, your business will become increasingly valuable. Not only on an absolute basis, but also on a relative basis. When we are looking to build up a company, we're generally focused on a lot of smaller companies. We would enjoy benefiting from having some of those things in place.
If we have a merger of equals, which is also often the case, it's a totally different program. You may in fact leave their systems alone. Maybe they have the better system. You may, in fact, take a manager out of the business that's being acquired and have him or her run the whole thing. You've got to be fleet of foot as you go through an acquisition-growth program, because you never know what you're going to encounter.
Richard Worthy: If we are considering a consolidating acquisition, and we, the buyer, have a suitable, existing IT system in that region and would want to consolidate the acquired IT system, then clearly from the acquirer's point of view the less IT investment made by the seller the better. However, the timing of a sale is rarely so convenient and accommodating, so delaying an IT implementation, particularly in the face of the Y2K issues, is extremely risky from the seller's perspective.
The question we increasingly see facing distributors is one of balancing future IT capabilities and future business needs with current expense and investment as a percent of total revenue. If a distributor has $50 million or $100 million in revenues today, but sees itself growing through acquisition to the $150-million- or $300-million-level in three to four years, it has a difficult decision to make. Does it invest in an enterprise or other degree-of-magnitude (or multiple degree-of-magnitude) more expensive IT system today? Not doing so could potentially limit the operational effectiveness of the business as it does grow, but investing now without current sufficient scale presents grave operating margin risk.
The balancing of IT, process and people will be one of the keys to servicing customers and maintaining high employee morale. Which, in turn, is key to productivity.
Moderator: How does buying-group membership of acquisition targets affect the valuation? How involved are the buying groups in deals? We always hear about distributors whose entire profit comes from their buying-group rebates. How does that play into your calculations?
Zepf: Well, to the extent that a company is A-D, good for them, because we are also. To the extent they aren't, it's probably an opportunity for us. So either way it works out to be a positive. They really don't get involved in the acquisition arena at all. Sometimes, someone will say, "This guy's for sale. Is it okay if he calls you?" Well, that happens not only with people in the buying groups but manufacturers and customers and other folks as well.
Brown: Profitability comes in a lot of different ways to a distributor. If it makes sense for someone to belong to a buying group, that's not going to attract us even closer or going to tear us away from that particular company. There are many good companies that aren't in buying groups and are highly profitable, also. But buying groups have caused additional problems for some companies, and you have to be able to prop those companies up.
Haley: We look at the overall performance and profitability of the business, and that is one component of anyone's financial performance. Generally, the supplier rebates are, in our view, earned in one form or another, and so we evaluate that. We take it into consideration in terms of the total picture, but don't attribute more or less value to it.
Moderator: Why might the owner of an electrical distributor consider selling his company to yours in particular?
Brown: We tell them, "Rexel is in the distribution business, and we're going forward in the distribution business. We're very flexible as we move forward. We're structuring something that will meet your needs. We think we're going to be a leader in the electrical distribution business."
Haley: We're attracted to organizations that are interested in developing their growth strategy. We're a partner with them, building their business in areas that are attractive to them.
Not every business is going to be a fit with ours. The distributor who has a lot of small counter operations is probably not going to be attracted to our business and we're probably not going to be attracted to theirs because there's not a good strategic fit. But where there's a fit in terms of direction and capability and customer base and intensity, we would be attracted to them and they would be attracted to us.
The most important elements are compatibility of management and a strategic fit. If you can't get across those two hurdles you're not going to be effective partners.
Formolo: The thing that we emphasize as we go around and meet with people-and this plays positive with some and negative with others-is that we're a pure play in utility-only distribution. For a lot of the people we've dealt with, who have been in the utility-only industry for their whole careers, that's a big positive.
The second thing that we emphasize-and again, this appeals to some and not to others-is that we're not a national chain. We're a very entrepreneurial, small company, even today. And within that environment opportunities exist for the owners of the companies we're trying to buy to continue to participate on a very active and direct basis going forward. They can continue to have a big impact on the business. They can do so through management. They can do so through ownership. We've always been very careful to try to craft a role that really meets with the seller's objectives. We have the ability, given our structure, to be extremely flexible in that regard.
We also pitch that while we're small on the one hand, we're a very deep pocket on the other hand. We have the ability to finance aggressive and rampant growth. Everybody in this roundtable can make the same speech. Every entrepreneur wants to be on a winning team, and to give somebody an opportunity to launch forward and be on a winning team can be very attractive.
We find that a big component of the compatibility that everybody here is referring to is the integrity level, the way you do business. By linking ourselves up with like-minded people, we've been very successful.
Zepf: The most important criteria for us is the fit with management. When we start into talks with a company, we try to structure the deal to meet their needs. We can do that very effectively, being a public company, because we can either offer cash or stock or a combination thereof, which allows them to become owners in our company on an ongoing basis. Or in some cases we've done some other things that have been creative from a tax standpoint. We're more driven by the needs of the owner-seller in terms of working with him on tax structure and ongoing issues they may have for trusts or estates, or anything like that, to make it work out for them.
So first we're flexible, and we can do a number of different things. Secondly, with regards to the integrity issue, we have to be very fair in doing the deal, because they are going to be a very big part of our company, and on the other side of the transaction, we need them to be a good partner for us, because they are going to be running this business. We give them a list of everybody we've done deals with, and we encourage them to call any of these companies. I think every one of them will vouch for us both before and after the deal, that what we say we're going to do, we do.
Thirdly, we can point to the companies that we've acquired and say, "They were well-run companies before. We didn't do anything to mess them up. They had great growth plans, and we helped them take it to the next level."
In most cases, that's what most of these people want to do anyway. They want to get out of having all the administrative burden, and we take that off them. Most of them were salesmen at one point in time, and they love getting back involved with the customers. We see a growth spurt pretty rapidly right after we join forces just because the former owner's back out working with the customer base again rather than being tied up working with bankers or lawyers, or buying insurance, or whatever they had to do. So those are primarily the major selling points we try to stress-that they're still going to run the business. We don't run businesses from Orlando. We can't.
Worthy: Number one on our list of reasons a distributor should join us would be the access to resources to assure fulfillment of the owner's vision for his or her business, which would most likely include sustaining future employment for their employee base. Sonepar is a family-owned, privately held company, and it has been willing to put its equity and its resources behind the idea of local autonomy and trust. We ensure that local autonomy and trust will be the key drivers in the company's success by limiting the amount of resources that can be used at our national headquarters.
With our limited presence in the U.S., we have a clean sheet of paper. We're not taking an existing corporate structure and culture and operating procedures and having to transplant that onto an acquired business. We are merging with companies more than buying companies, from an operating viewpoint. We don't come in with the Sonepar Way, we don't come in with a rule book with 'X' number of turns per SKU. There are a number of very well-run distributors that, at this point in time, for a multitude of reasons ranging from succession planning to access to resources and capital, have interest in joining an organization where they are setting the tone of the culture in their geographic region.
Moderator: What are the valuation expectation levels that you've seen, and what would you say are unreasonable expectations?
Zepf: In terms of unrealistic expectations, I think there are some business brokers out there who do a huge disservice to their clients in terms of trying to pump up expectations in a lot of cases. We only buy private companies and have never purchased a public company. So you get some of these "experts" who think that somebody's going to pay a public-market multiple for somebody that's less geographically dispersed, or maybe the profitability's less than yours, or whatever. It makes it very difficult to bring those expectations back down again.
That's usually one of our biggest problems. They have inadequate representation in terms of a business broker, or maybe even a lawyer, or somebody that's representing them in the negotiations that sort of pumps the deal up beyond what you or anyone else would do.
Brown: I attended a recent industry meeting where the facilitator addressed that question. He looked at a lot of industries. He looked at distribution. And then also specifically what we're doing in electrical distribution. And it seemed to be a realistic market level there, in a range of six to seven of EBIT (earnings before interest and taxes).
Worthy: It's a tough question to answer because not all distributors' balance sheets and income statements are created equal. A dollar's worth of revenue with one distributor may not correlate to the same ROS (return on sales), debt to equity, net equity as it would to another distributor with the same revenue. However, most financial advisors quote multiples as if none of the other factors exist. What should really matter to an owner is not what multiple he received, but how much money he put in his pocket. Most financial advisors can figure out what range of multiples was paid on previous deals of similar scale, but few can tell their clients what the true net proceeds to the seller were.
What is the size of the business? What is its growth potential? Is it a platform or a consolidating acquisition? Do they have a viable plan to double the business if the needed resources were made available? Do they have positive cash flow? All these are considerations thatI feel will become more important as the robust economy we have experienced over the past years begins to slow. Can the current management team grow into the expanded leadership role needed to take a business from, say, $70 million to $180 million? All of these and other items impact the valuation from the buyer's perspective.
When I was at GE Capital, we favored negotiated deals. Currently, in this industry, I prefer a bidding process because then the market sets the level and the owner sees what prices are truly out there, and a more objective and amicable process usually occurs.
Moderator: Apart from financing, where deals have fallen apart, what could have been done in those situations in order to avoid that?
Haley: Obviously, you have a lot of issues in negotiations that you may think are financing issues that turn out to be something different. As Steve said, most of the transactions that we're dealing with are private company transactions, so they probably wouldn't be very visible in terms of what the financing characteristics will be. The reason deals don't get done is back to this issue of strategic fit. A good partnership and a good framework for strategic compatibility are certainly a starting point.
Zepf: We had some difficulty when the market started flipping around here on us because we had some deals that were priced as stock deals. We had to try and save them because of the market's fluctuations. That was a particularly trying situation. But it was one that, because they wanted to do the deal and we wanted to do the deal, we were able to work through it.
We have found that whenever you're in that type of situation, there're not too many problems that you can't get over, other than maybe some really strategic things that you might bump up against. But if you have somebody that really wants to do it on one side, and we want to on the other, there's some way to work most issues out.
We've had some that, because of some environmental issues, we couldn't work it out. Some due-diligence-type things like that have come up that have caused us to walk away. But then the issues got resolved, and we put the deal together a year or two down the road. Sometimes an owner just gets cold feet and says, "I'm just not ready to sell." But we've had some of those come back around.
Worthy: Often when talking with an owner you get the sense that he or she isn't really committed to selling. It only becomes truly clear later in the process, however. A real issue to this industry consolidating is the fact that many people and companies have different reasons for being in business and do not need to sell. They have relatively good financials and, depending on their own expectations regarding return on equity, debt to equity, risk appetite, they could stay independent for quite some time. Thus we look for businesses that have a clear vision for their company and want a partner who brings complementary skills or other resources. If the owner is not certain of why he or she is selling and what he or she is looking for in a partner, the chances of a non-financial parting of the ways is more likely.