Consolidation: Changing the Landscape

The times are a changing. While the industry has benefited from commodity price inflation, a rebound in industrial MRO expenditures, significant residential growth and continued improvement in the commercial marketplace, this “perfect storm” is creating acquisition opportunities for some.

Before the past is forgotten, many industry observers will recall the hard times that fell upon the industry. Distributor net profits were about 1 percent, industrial flight to China was in full swing and dot-coms became dot-bombs. Many electrical distributor businesses suffered, and a number of owners lamented that they did not sell their businesses during the “good times,” like some of their brethren.

Recognizing that the acquisition market was dry, companies either crafted growth strategies to gain share, improved operational processes to reduce costs, implemented both of these strategies or continued to persevere and maintained their income (a lifestyle company).

Fast forward to today. Distributor revenues and profitability have improved. Leading companies made investments in technology. Industry stalwarts are aging. Larger distributors seek new areas of growth, and capital is available from banks and other investors.

Last year, there were more than 30 electrical distribution acquisitions. It looks as though the conditions could be ripe for more. The electrical industry may see much change to its landscape.

Channel Marketing Group and Allen Ray Associates recently surveyed and interviewed more than 100 industry thought leaders to understand why people sell, whom they believe acquirers will be and how consolidation may affect the industry in the next three to five years. Distributors and manufacturers of all revenue sizes responded to the survey.

Survey respondents believe that the Top 100 distributors will account for 60 percent to 65 percent of industry revenues in three years or about $18 billion to $20 billion more than today. Most of this revenue aggregation will be due to distributor consolidation.

Who will acquire?

Survey respondents focused on many of the expected acquirers. Expected acquirers frequently mentioned included Sonepar (by 34 percent of respondents), Home Depot (15.7 percent), national/regional chains (11.1 percent), Rexel (8.5 percent), private equity (7.2 percent), Lowe's (4.6 percent), global players (4.6 percent) and Consolidated Electrical Distributors (CED, 3.3 percent).

Additionally, nontraditional potential acquirers could include:

• Asian or Indian manufacturers seeking distribution.

• Ferguson, a division of Wolseley PLC with headquarters in Newport News, Va., and $19.7 billion in annual sales. Ferguson made more than 25 acquisitions in 2005, purchasing plumbing companies with significant electrical revenues.

• Interline Brands, Jacksonville, Fla., with $800 million in annual sales. This multi-industry public company has a number of electrical groups and extensive private labeling experience.

• WinWholesale, Dayton, Ohio, the purchaser of Noland Co., Newport News, Va., with more than $2 billion in revenues, 500 locations, and an estimated $200 million in electrical revenue.

• CES, with U.S. headquarters in Orlando, Fla., focuses on start-ups and plans to move into five to seven more states in the coming year. The company's British owners have quietly expanded past the CES stronghold in the southeastern United States.

• Private-equity companies either on their own or supporting industry veterans. According to Thomson Venture Economics, private equity firms raised $83.5 billion in 2005, which could be leveraged into $400 billion in buying power. A percentage of this is targeted at distribution and industrial manufacturing.

Regional distributors, too, expect to grow through acquisition, expanding into new markets with contiguous acquisitions and continuing to make smaller acquisitions to “fill-in.” This is especially important for Rockwell Automation distributors because Rockwell reportedly wants to reduce its distributors from 50 to 60 to about 20 firms. Large contractor houses will also make acquisitions to develop greater efficiencies and increase their market share. In fact, survey respondents expect 8.5 percent of their future revenue growth to come from acquisitions.

Why sell?

For the past 10 years, the lack of succession planning and the dearth of incoming talent to the industry have been frequent topics at industry meetings. This, coupled with continued distributor investments in technology and the perception that some distributors “missed” prior selling opportunities, are converging to accelerate the consolidation trend.

Survey respondents indicated:

• 59 percent believe companies sell due to lack of a family succession plan.

• 57 percent express concern about the future of the economy and their ability to cash out later.

• 53 percent view themselves as stewards of the family business with a fiduciary responsibility to the family.

• 48 percent are reluctant to further invest in the business.

• 24 percent perceive that distributors were not making enough money.

• 10 percent are concerned about forming an ESOP.

The recent high-profile acquisitions of Rexel, Hughes Supply and Stuart C. Irby have further heightened interest in selling due to the multiples that were paid. Home Depot paid 12-times to 13-times earnings. According to sources, the other deals were high-single to low-double-digit multiples. The reality is that these acquisitions were strategic platforms for the acquirers, and hence they may have overpaid.

The wisdom of strategic acquisitions can usually be determined within 12 months to 18 months. Historically, if an acquiring company does not receive synergistic benefits within a year, it does not achieve those advantages long-term.

According to acquirers and financial buyers, future deals will be closer to six-times to eight-times EBITDA (earnings before interest, taxes, depreciation and amortization). The key to receiving a higher multiple is for the acquiree to be positioned as a growth-oriented, strategic acquisition.

Does it matter who acquires?

Industry insiders say “yes.” Private equity firms have access to capital and will fund acquisitions that accelerate consolidation. These “professional money people” will bring improved financial discipline to the industry and increased focus on achieving supply-chain efficiencies, survey respondents believe. Professional money will bring an enhanced passion for profits, as well as a desire for growth to accelerate the value of their investments.

Conversely, survey respondents believe “industry outsiders” will focus on profits to the detriment of the business, resulting in a loss of customer focus at acquired locations. Respondents also believe that if industry outsiders acquire an electrical distributor, the company's customer and supplier relationships will wither, employees will seek security and a short-term mentality will prevail.

Similarly, few believe companies on the “outskirts” that don't focus on this market will be able to succeed — perhaps because it hasn't often been done before or perhaps because the “right” structure has not previously been implemented.

The accelerated pace of acquisitions bodes of future challenges and opportunities for distributors and manufacturers. It would not surprise us to see 200 less independent distributors in three years (a 6 percent reduction). The increase in revenue that survey respondents expect for the Top 100 distributors will be important for channel participants to re-evaluate their strategies.

ELECTRICAL DISTRIBUTOR ACQUISITIONS IN THE LAST SIX MONTHS Acquirer Acquiree Border States Electric Supply, Fargo, N.D. Nunn Electric Supply, Amarillo, Texas Communications Supply Corp. (CSC), Carol Stream, Ill. Calvert Wire & Cable Corp., Brook Park, Ohio Stuart C. Irby/Sonepar USA, Jackson, Miss. Priester Supply, Arlington, Texas The Hite Co., Altoona, Pa. six Pennsylvania Hagemeyer locations; one West Virginia location The Home Depot, Atlanta Hughes Supply, Orlando, Fla. Viking Electric Supply/Sonepar USA, Minneapolis Boggis-Johnson Electric Co., Milwaukee Werner Electric Supply Co., Neenah, Wis. Best Electric Supply Co., Milwaukee

Manufacturer/Distributor Relationships

With size comes “power,” defined as the potential to leverage the business. If 60 percent of revenues are sold through the Top 100 (3 percent of all electrical distributors), many expect larger distributors to receive preferential pricing, larger rebates, increased marketing support and more personal attention. Size will matter and relationships, while important today, may not be as important in the future.

The volume that these companies bring may come with a sharp edge — the perception that the distributor controls the business and that manufacturer products are commodities. This could lead to switching suppliers based upon line profitability and/or a heightened interest in private labeling.

For manufacturers, marketing and training could become differentiators and reasons why smaller distributors stock their lines. Branding will become more important as the need to gain greater access and influence at the end-user becomes essential for a manufacturer to support its business.

Manufacturer profitability may further shrink with the need to serve the larger distributor, enhance branding efforts, market to smaller distributors and focus more on end-users. In an effort to maintain acceptable profits, manufacturers will seek to work with distributors who offer supply-chain efficiencies (something Home Depot knows a lot about) and help the manufacturer differentiate itself in local markets.

We asked survey respondents how manufacturers might refine their distribution strategies. The top-10-expected strategies are listed in the side bar below.

Notice the focus on large distributors. Small- to mid-sized distributors need to consider how to capture share of mind from the manufacturer, and manufacturers will need to consider how to balance their efforts to take advantage of market opportunities and capture their share of the remaining 40 percent of the business.

The Role of the Rep Evolves

A potential major “casualty” of consolidation is the role of independent manufacturer sales reps. Many believe that reps will need to become better custodians of their markets. They will need to focus more time at the end-user, gain specs from influencers, and generate demand. Expect increased rep consolidation due to the need for reps to offer more services.

Large distributor relationships will be managed by national account managers with reps supporting initiatives in executing roles. Small distributors will be the domain of reps who will maintain their traditional roles of distributor development, account management, local marketer and demand creator with these customers.

But with a significant percentage of the business being managed at a corporate level, and reps being relegated to implementers of strategy, many believe that the rep compensation model will change. It's doubtful that it will be based 100 percent on volume. More likely, it will be a combination of marketplace volume, account profitability and demand generation activities.

A key for manufacturers will be determining the profile of the “right” rep, identifying how to communicate with them and providing the tools that they will need to achieve manufacturer-defined goals. Manufacturers will also need to strive to identify what the “right” compensation model is. Perhaps piloting initiatives now would be appropriate.

If you're a rep, evaluate your market. Where do you expect consolidation? How do you need to change your organization to deliver value-added to your manufacturers and distributors? What is the “right” compensation model for you? How could you become a marketing engine for manufacturers or selected distributors?

An Opportunity for Independents

Change creates opportunity. Although some independent electrical distributors will view the next few years as a time to cash out, others will see it as an opportunity to focus and grow business.

According to survey respondents, independent distributors with the following traits, priorities and goals should prosper:

• Service their customers.

• Strong customer relationships.

• Commit to a market segment and/or identify niches.

• Are nimble.

• Respond to customers.

• Have low employee turnover.

• Are operationally efficient.

• Have strong balance sheets to financially take advantage of opportunities.

To enhance their competitiveness, these distributors should:

• Stock appropriately, recognizing that national chains have a tendency to focus on financial measurements vs. customer needs.

• Belong to a marketing group to take advantage of enhanced rebates, networking opportunities, education and marketing support.

• Identify ways to generate operational efficiencies through technology and/or alliances.

• Become more proactive in marketing their differences and supporting supplier initiatives.

Although consolidation may accelerate, there will always be many more independents willing to work with a manufacturer for a mutually beneficial relationship.

Marketing Groups … More than Rebates

While some believe that marketing groups will decline in importance with the loss of larger members, they still will represent a significant number of distributors, more than 1,200, with revenues accounting for about 25 percent of industry sales.

Historically, the principal benefits of the groups have been financial, networking and market planning tools. As the industry consolidates, independent distributors will look to the groups to provide a broader array of services.

From marketing groups, survey respondents will be looking for increased education and training support in areas such as product, developmental skills and marketplace trends; access to products at better prices through group buying; marketing resources that small distributors can utilize; and opportunities to reduce operational expenses through either group buying or technological services.

From a manufacturer viewpoint, the marketing groups could become more important as a channel strategy. Although the rebate expense is significant, many distributors would earn a significant portion of the rebates that are currently paid regardless of belonging to a group. Perhaps the benefit of participating in a group for a manufacturer is enhanced interaction with distributors (given that all members attend A-D, IMARK and Equity/EDN meetings) and access to more effective communications systems. Manufacturers should consider how to gain greater benefits from their memberships. And, perhaps the groups should more effectively market these value-added services as core competencies.

Declining Association Membership

In the words of one respondent, “Trade associations serve the industry regardless of make up. NAED will still exist if there are only 50 players.”

Although the survey asked for input regarding “associations,” most responses related to the National Association of Electrical Distributors (NAED), St. Louis.

Respondents unanimously believe that the association will lose members and should continue to focus on standards and education, identify ways to reduce channel costs and enhance distributor profitability, and promote a method for distributors to “quantify” the value of the association.

Some expressed that they like recent NAED efforts to highlight industry issues, even though the association is challenged with implementing task force recommendations. The input is beneficial to those who read/hear it.

Many believe that NAED meetings will become less important with attendance dropping and that marketing-group meetings will have more value (coupled with more small distributors joining the marketing groups). Survey respondent believe the association should consider alternative revenue streams, streamline resources and maximize its usage of technology.

To serve the industry in the future, it will be important for distributors to expand the involvement of their people in the association and possibly for the association to niche itself, offering services that are more appropriate for larger companies while having other services for small distributors.

Developing a Plan

For some, distributor consolidation may be an “early Christmas present” enabling them to secure their future. One national distributor suggested that “every $25-million-plus distributor should develop a three-year plan, forecast revenues and profits, show how they can grow and see what they are worth.” Although there may not be a buyer for everyone, the process of planning, by definition, determines company direction. Those who focus and execute can win.

Manufacturers have broader challenges. Some will be consolidated, but channel challenges will require manufacturers, and their sales agents, to re-evaluate distribution policies and strategies. Much power today is at the end-user level. If distributors gain influence with the end-user, how do manufacturers need to react?

The full effect of consolidation won't be felt for a couple of years, but now is the time to “white board” ideas, develop concepts, test pilots and launch initiatives.

Allen Ray is principal of Allen Ray Associates, Dallas. The consulting firm helps manufacturers and distributors discover their true profit potential. Ray can be reached at (817) 704-0068 or [email protected]. Visit the firm's Web site at www.allenray.com.

David Gordon is a principal of Channel Marketing Group, Raleigh, N.C., which develops growth strategies for manufacturers and distributors. He can be reached at (919) 488-8635 or [email protected]. Sign up for Channel Marketing's monthly newsletter at www.channelmkt.com.

Big Orange Heightens Electrical Visibility

In the words of one industry veteran, Home Depot's acquisition of Hughes Supply could be a “watershed event” for the industry — not because of Home Depot entering into electrical distribution but because of the cache of the Home Depot name to generate interest in the industry, and discussion among distributors and manufacturers. Will the heightened visibility change industry practices?

Many say yes. Manufacturers expect that the combined organization will seek “low” prices and “high” rebates, as they uncover the negotiations of the combined organizations. It's also expected that Home Depot will bring its operational best practices to Hughes. Alternatively, new services could be developed such as national accounts for large homebuilders to “kit and stage” houses, small projects and multi-unit facilities that require multiple trade-groups.

Nonetheless, only 10 percent of Hughes was electrical. Potentially more important to Home Depot was Hughes' MRO, waterworks and plumbing businesses. The MRO business helps Home Depot's Maintenance Warehouse business and government service contracts; plumbing/HVAC is a natural fit for a company that excels in servicing homebuilders, remodelers and contractors; and the water and sewer businesses complement Home Depot's waterworks group.

Many of these trades are transactional-driven industries. Electrical is more complex, especially the commercial and project aspects of serving customer needs.

But the visibility may accelerate change.

Top 10 Expected Manufacturer Responses to Distributor Consolidation

When asked how manufacturers might refine their distribution strategies as a result of anticipated electrical-distributor consolidation, survey respondents identified 10 expected strategies.

1. Seek to strengthen relationships with independents.
2. Electronically integrate with large distributors.
3. Increase usage of national account managers.
4. Change the role of manufacturer reps.
5. Maintain level of rebate to marketing groups.
6. Seek distribution alternatives on fear that the consolidating distributor's service levels may decline.
7. Provide special customer pricing to servicing distributors.
8. Provide more marketing support to large distributors.
9. Provide special pricing allowances to large distributors.
10. Provide greater volume rebates to large distributors.

Notice the focus on large distributors. Small- to mid-sized distributors need to consider how to capture share of mind from the manufacturer, and manufacturers will need to consider how to balance their efforts to take advantage of market opportunities and capture their share of the remaining 40 percent of the business.