Opposing forces hindered distribution M&A so far this year. While economic and commodity pressures have cut down on the volume and size of deals, lack of organic growth has companies seeking acquisitions to boost their top lines. This article looks at the current state of M&A and what’s in store for the second half of 2016.
As end markets carried over their struggles from the fourth quarter of 2015 into the first quarter of 2016, merger and acquisition activity in distribution has mirrored that overall economic softness with smaller and fewer deals. But like the economy, M&A is poised for a strong finish to 2016 as private equity firms prepare to deploy capital and strategic buyers look to acquire growth and increase market share.
So far, however, three overriding themes – energy, price transparency and the strong U.S. dollar – have slowed the pace of M&A across distribution, especially in the industrial space, according to Jason Kliewer, co-head of Baird’s distribution investment banking group.
“All of those key themes have meant that it’s been a little harder to demonstrate the growth of a platform, and there’s been a slowdown in upper middle market M&A this year,” Kliewer says. “But at the same time, distributors are continually looking for ways to augment the top line so they have been active with bolt-on acquisitions.”
Energy, in particular, stunted M&A activity as revenues, earnings and valuations tumbled, most notably among industrial distributors. Companies divesting divisions with exposure to oil & gas was the exception.
“For industrial supply distributors, there may be more of an energy exposure than people realized a few years ago, even if it’s only 5 or 10 percent,” Kliewer says. “The energy theme is one of the big ones. As that’s unwound over the last year, it’s dragged down organic growth for a number of distributors not typically viewed as energy focused.”
Focus on core strengths
With headwinds creating overall softness – distributors averaged -0.1 percent revenue growth in the first quarter, marking the second consecutive quarter of negative growth, according to the most recent MDM-Baird Distribution Survey – potential strategic buyers have been primarily looking at strengthening their own businesses instead of targeting new assets.
“They’ve been saying, ‘I need to focus within my four walls, execute my strategy and find efficiencies to maximize my earnings in what is a softer end market,’” says Reed Anderson, head of Houlihan Lokey’s industrial distribution practice.
Distributors are even looking to shed underperforming divisions or adjacent businesses where they simply no longer want to spend time and energy, as HD Supply, Atlanta, GA, did recently when it agreed to sell its HD Supply Interior Solutions business unit.
The current economic climate – improving but not robust – is an ideal time to adapt to changing market conditions by strengthening your core and executing within it. If you don’t want to invest in a part of the business, for whatever reason, it’s time to get out.
“Boards are looking more closely at lower-priority items when things aren’t going up and to the right,” Anderson says. “It’s not just dollars that they’re interested in, but also management time.”
Reinforcing and reinvigorating the core will play a factor in the deals that do – or don’t – happen. A company has to know itself first before getting to know anyone
else and making an acquisition, according to Dave Gabriel, president, Sonepar North America, Charleston, SC, who spoke on a panel at the National Association of Electrical Distributors national meeting this month in Washington, DC.
“Look at your core business today and say, ‘What am I really good at? What do I do well and do better than someone else? What is close to that? I think I can create some traction and some scale,’” Gabriel says. “If you have an alignment … then maybe it makes sense. Know yourself first. Chasing volume for the sake of volume, or chasing geography for the sake of geography, I wouldn’t advise that for anyone.”
“Slight pullback” in volume, quality
Yet some distributors have an opposite mindset of “We’re going to do all that, but we know we’re not going to grow at the top-line rate we’d like to grow. And we need M&A to augment that growth, particularly in the industrial sectors that might be a little bit softer,” Anderson says.
The result of these conflicting forces has been a tepid M&A market that hasn’t matched the volume and size of deals from a year ago, when M&A was flush with high-dollar and high-profile acquisitions.
“You factor all that in and we are seeing a slight pullback in volume as well as the quality of companies in the market selling their businesses, both private equity-owned and family- or founder-owned businesses,” says T.J. Monico, head of distribution, investment banking, KeyBanc Capital Markets.
According to data from Supply Chain Equity Partners’ proprietary distribution database, there were 465 wholesale distribution transactions completed in 2015. Of those, 322 were strategic buyer transactions, 79 were private equity-backed strategic buyers and 64 were private equity-backed platforms. (See Figure 1).
The 2015 total was up 34 percent from 2014 (see Figure 2) and continues the S-curve of M&A in distribution – a period of numerous acquisitions, followed by a period of entrepreneurs breaking off and starting their own businesses, followed by another period of acquisitions. The drop-off in M&A activity this year, even slight, furthers this cycle.
“That is going to continue in this industry,” says Jim Miller, a principal and founder at Supply Chain Equity Partners, speaking on the same NAED panel that featured Gabriel. “You’re going to have waves of consolidation and waves of new businesses expanding. And you’re always going to have dozens and dozens of companies that don’t have succession planning, so when it comes time, they’re going to need to sell.”
Slow or immediate growth?
The modest pace of economic recovery bodes well for increased M&A activity as companies look for other ways to boost their top lines, Monico says.
“Organic growth is going to be a challenge, given that we’re not firing at all cylinders right now,” he says. “Companies will look to supplement organic growth with acquisition growth. It’s cheaper to buy growth than to wait for organic growth to return.”
Purchasing competitors in new markets or even expanding their product focus is also the fastest way for distributors to prosper as they look to balance organic and acquisition growth, according to Sonepar’s Gabriel.
“In a slow-growth environment, which I think we’re in, execution on organic (growth) is extraordinarily important to all of us, and then selective targets on the acquisition side is even more important,” Gabriel says.
Acquisitions are equally important for regional distributors, yet many of those companies remain hesitant to acquire too much too quickly, which has cut down on the number of deals across distribution.
For example, HVAC, refrigeration and plumbing distributor F.W. Webb Co., Bedford, MA, has made three acquisitions in the past year – Grant Supply, Water Works Supply Corp. and State Line Supply – but while buying adds market share, the company often has to say no or “wait and see” if the deal might
make sense later, COO Bob Mucciarone says.
“You want to improve the top line, but you don’t want to do it at the expense of the bottom line,” Mucciarone says. “You want the top line to grow at the same slope as the bottom line. If you do too many, too quickly, your top line will grow but your bottom line will go the other way.”
New themes emerging
A few themes emerged in distribution M&A last year, most notably financial and strategic buyers increasingly competing for the same targets. While that is still true to a degree, most strategic buyers are “staying within their lane” this year, Anderson says.
“In periods of economic boom, it’s easier for strategics to move outside their lanes and get into adjacencies that may be complementary business,” he says. “In the market we’re in today, we’re seeing strategics be much more focused.”
Another difference in 2016 is a lack of blockbuster announcements. This year has seen large distributors adding small companies that meet a geographic or product need, while last year saw several high-profile deals that included Air Liquide acquiring Airgas, Builders FirstSource acquiring ProBuild, Anixter acquiring the Power Solutions Division of HD Supply, The Home Depot acquiring Interline Brands, Beacon Roofing acquiring Roofing Supply Group, and Stock Building Supply merging with Building Materials Holding Corp.
Also unlike last year, when building materials & construction consolidation was rampant and big deals in that space were routinely announced, no single sector has emerged as an M&A leader so far in 2016.
“There’s so much diversity across a lot of the distribution landscape here that even when you look within industrial you can find certain categories that are way up and certain categories that are way down from an end-market perspective,” Anderson says. “Both of those can drive M&A – some wanted M&A and some unwanted M&A if you’re struggling and have no other option.”
Other sectors have shown flurries of consolidation, from gases & welding equipment to HVAC & plumbing, yet industrial supply and building materials & construction should see the most activity, especially from private equity buyers, as they did last year (see Figure 3).
While most analysts agree that it’s difficult to predict what will happen with M&A in distribution for the second half of 2016, most forecast a bump from the first half as the economy improves. Strategic buyers will look to buy growth and financial buyers will deploy capital in distribution.
“What’s going to happen the remainder of the year is a tough question to answer,” Miller says. “There’s still tons of cash on the sidelines. The strategic buyers are dominating the market right now, but that comes in waves, as well. There’s a trillion dollars of buying power in private equity right now, and they have a period of time that they need to invest that money. With every day that passes, that money needs to be invested, and there’s increasing pressure to invest that money.”
Part 2 will outline strategies for companies looking to buy or sell in today’s M&A landscape.