Unlike previous cycles of strong merger and acquisition activity in distribution, today’s market is unique in that strategic buyers and private equity firms are going after the same targets, setting the stage for an especially compelling consolidation story in the second half of 2015.
When the Great Recession ended, merger and acquisition activity began a generally upward trajectory in terms of volume. Deal activity peaked in the last quarter of 2012 in advance of tax changes being implemented, but excluding this spike volume has generally continued to grow.
Domestic M&A activity across all industries equaled that peak in third-quarter 2014, according to Houlihan Lokey, and while that number has dipped in the two subsequent quarters, all signs point to continued consolidation for distribution in 2015 and beyond.
“The M&A market today is as strong as it’s ever been,” says Reed Anderson, head of Houlihan Lokey’s industrial distribution practice. “That’s generally speaking, but it’s particularly true in the distribution space.”
While the industry has seen strong M&A cycles in the past, usually it has been driven by either the strategic buyers – big players looking to expand and get bigger – or by private equity firms looking to invest in the industry. What makes this cycle different, according to Anderson, is that strategics and private equity firms are competing for the same targets.
Strategic buyers still make up the lion’s share of distribution M&A transactions. According to data from Supply Chain Equity Partners’ proprietary distribution database, there were 331 distribution transactions completed in 2014. Of those, 213 were strategic buyer transactions, 47 were private equity-backed platforms and 71 were private equity-backed strategic buyers. (See Figure 1).
A “Unique Confluence”
The M&A market in distribution is “incredibly strong right now” because of the industry’s financial strength and stability, says Jason Kliewer, co-head of Baird’s distribution group.
Theoretically, it makes sense that strategic buyers would be willing and able to pay more for a business because of their ability to capitalize on synergies, but recently private equity has been able to outbid strategic buyers on many deals. Private equity firms have an abundance of cash on hand from investors and financing is cheap – meaning more money is available for larger deals. And distributors have proven to be valuable targets.
“The private equity community – both mid-market funds that have traditionally invested in distribution, as well as the larger cap funds – has really looked at distribution models,” Kliewer says. “They saw the performance through the downturn, the cash generation of distribution in 2009 – for many distributors that was a record cash year. From an ability to finance a transaction with leverage, that’s very attractive in terms of risk.”
On the strategic buyer side, slower-than-desired overall gross domestic product growth in the U.S. appears to be hampering organic growth for many of the key players. As a result, companies that haven’t historically been known as acquisitive are looking for ways to augment their balance sheets, while at the same time, historically acquisitive strategics are picking up the pace of investment.
“It is a low-growth environment for a lot of larger strategic buyers, and one of the ways they can continue to grow is to make an acquisition and cross-sell a broader product range,” Kliewer says. “In addition to those cost opportunities, the ability to take an acquisition and accelerate what would then be organic growth through cross-selling is very attractive.”
This “unique confluence” of factors – strong financing markets, high cash availability and strategic buyers looking for growth – are keeping the M&A market hot for distribution, Anderson says.
But it also means that it is a seller’s market, says Jim Miller, a principal and founder at Supply Chain Equity Partners. Sellers have high expectations for valuations, because they’re seeing those valuations in the market.
However, conditions may be shifting slightly in favor of buyers. “It’s becoming a little bit more
of a favorable buyer environment,” says Charley Hale, president of FCX Performance, a distributor of process flow control products. “We definitely see the number of opportunities out there increasing.”
Hale says FCX has a “very robust pipeline” as it looks to acquire companies in the range of $25 million to $50 million in annual revenue, and that potential sellers are receptive to the offers being made.
While activity in distribution is broad-based, some sectors are stronger than others. Industrial distributors, particularly those dealing in maintenance, repair and operations-related products, continue to be strong targets. And aftermarket automotive has seen a lot of activity over the past year, Miller says.
“But the sector that seems to be getting strong and building momentum is building products,” he says. “In terms of just deal volume, we’ve seen a lot of stuff in the building products space.”
Certainly some of the largest M&A deals in distribution so far in 2015 have been in the building materials space. In April, Builders FirstSource, Dallas, TX, agreed to acquire Denver, CO- based ProBuild Holdings LLC for $1.6 billion.
And rumors have been floated that US LBM Holdings LLC, Green Bay, WI, is for sale with expectations that it could fetch $1 billion at auction, according to a report from Reuters. Meanwhile, the building materials distributor has been buying up a slew of other companies, completing 14 acquisitions in the last nine months.
Housing and construction has been among the slowest areas to recover from the Great Recession, though several analysts say that it’s hit bottom. Building products is a cyclical market, Anderson says. “The market has moved and now it’s in the upswing.”
The economics of the U.S. residential construction sector, which has seen housing unit starts climb back to 1 million or more per month, bodes well for the building materials sector as it stages a slow but steady recovery.
“The market hasn’t rebounded strongly, but there’s a lot of excess capacity in some areas of distribution of building products,” Kliewer says. “And at the same time there are more experts that think we’re in for a longer, slower recovery, which in many ways is more conducive to a longer-term growth potential for the sector.”
Oil and gas-related businesses are the exception to the strong activity. “That sector kind of shut down for a while because of the quick decline in prices for oil, so any activity you see there now is more borne out of the distress side,” Anderson says.
The significant deflation experienced in the price of oil since July 2014 also adds a lot of uncertainty for businesses that are impacted directly and indirectly by the economics around oil and gas.
“That deflation in oil has been causing deflation on a lot of byproducts that run through distribution,” Miller says. And that may be responsible for some of the pullback in M&A activity in some areas.
There’s also uncertainty around the financing market. While it’s as good as it’s ever been, “no one expects it to get better,” Anderson says. So the question over everyone’s heads is when is it going to go the other direction – and how quickly?
For now, expectations are for continued financing strength, but the concern is out there, he says.
Limited volume of exceptional targets may also be slowing activity, according to Miller. “The deal flow is still pretty strong, but there was tremendous pull-forward of deal activity in 2012 in advance of tax rates going up,” he says. “I’m not sure how many companies that were pulled forward in their natural evolution would have been on the blocks around now.”
“It’s harder and harder today to buy solid platform businesses versus where it was a number of years ago,” Anderson says. “People are willing to stretch more on valuations.”
However, the positives in distribution M&A continue to outweigh the negatives, and activity is expected to be strong through 2015.
“I see over the next couple of years, unless there’s a market correction or any of the unknowables that can come our way, a continued strong M&A market for distribution,” Kliewer says.