A Distributor s Guide to Navigating Industry Consolidation

A Distributor s Guide to Navigating Industry Consolidation An I.B.I.S., Inc. Whitepaper by Brent R. Grover Research Fellow NAW Institute for Distribution Excellence www.ibisinc.com

Table of Contents Executive Summary Root Causes of Consolidation Consolidation of Distributors Consolidation of Suppliers Effect of Consolidation on Trade Associations Effect of Consolidation on Buying Groups Effect of Consolidation on Sales Function Effect of Consolidation on Marketing Effect of Consolidation on Information Technology Effect of Consolidation on Human Resources Effect of Consolidation on Financial Performance Effect of Consolidation on Exit Strategies Recommendations About the Author About I.B.I.S., Inc. About Advanced Supply Chain Software for Microsoft Dynamics AX 1 2 2 3 4 4 5 5 5 6 6 6 7 8 8

1 Executive Summary The process of combining smaller distribution businesses into a more effective, coherent business is accelerating. Consolidation also continues at the supplier level. Absent the appearance of black swans, we expect that these trends will continue. Consolidation is disruptive to all of the stakeholders in the channel. Longstanding relationships between distributors and suppliers are altered, trade associations lose members and the purchasing power of buying groups may be reduced. Some large distributors are making acquisitions to build a one-stop shop strategy by providing a much wider range of products. Distributors, suppliers and other channel members are rethinking their strategies in response to the consolidation movement. Some are finding new opportunities while others are on the defensive.

2 Root Causes of Consolidation Demographics are a factor as more baby boomer distributor owners reach their retirement years. Pressures to sell the business are greatest when the family has no ownership succession plan. Employees occasionally buy these companies, through an ESOP or direct ownership, but most of the businesses are sold to outsiders. Economic conditions continue to favor the sale of businesses, particularly as interest rates are low and banks are willing to finance acquisitions. Capital gains tax rates, despite the increase from 15% to 20%, are still attractive to sellers. The reinstated estate taxes are a catalyst for sale for some families with large estates, especially owners those who haven t undertaken good planning. Investment markets also favor the sale of distribution businesses. High stock market valuations affect the prices buyers are willing/able to pay for acquisitions. The familiar multiple of EBITDA formula (earnings before interest, taxes, depreciation and amortization) is high in strong investment markets, and is even larger for bigger distributors. The aggressiveness of financial buyers is a major factor in higher valuations of distribution businesses. Private equity funds have very large amounts of committed capital available from their investors. Many of these funds recognize that distribution acquisitions can be very attractive investments. A typical buy and build strategy is to acquire a large distributor as a platform company and buy many smaller distributors to create a bigger company. The strategy is based on the fact that buyers pay higher multiples for larger companies. Strategic buyers are also paying high prices for distributors. Profitable distributors have cash to invest. Larger buyers have access to capital markets at historically low interest rates. Publicly owned distributors are also enjoying higher valuations of their own stock. Many of these companies are anxious to jumpstart their growth through acquisitions. Consolidation of Distributors There was a wave of distributor consolidation in the 1970s and 1980s in many trade lines as some regional distributors scrambled to build a national network of locations. An example from the paper industry was a series of purchases by publicly owned Alco Standard Corporation (later called Unisource).

3 Another movement from those decades was a strategy by manufacturers to vertically integrate by buying distributors of their products. Another example from the paper industry was a series of acquisitions by paper manufacturers (International Paper, Mead Corporation, Champion International, Union Camp). Two of those manufacturers no longer exist and one merged with another company. The one remaining firm, International Paper, no longer owns paper distributors. International Paper recently spun off its distribution business, xpedx, and merged it with Unisource to create a new company called Veritiv. The moral of the story in the paper industry is that dozens of family-owned distributors were combined into, ultimately, one entity. In the 1990s there were numerous instances of roll-ups in which acquirers created a new corporation and used their stock to buy smaller distributors. Examples include U.S. Office Products in the office supplies industry and IDG, Industrial Distribution Group, in the industrial supplies business. The evolution of IDG, originally nine independent distributors who became a publicly-held company in the roll-up, illustrates a newer trend: consolidation of the wholesale distribution industry. Sonepar, a large electrical distributor, acquired IDG in 2014. Sonepar already owns the North American operations of Hagemeyer, a large industrial supplies distributor 1. Some large distributors are expanding their product offering to become one-stop sources of supply to customer segments such as facilities managers. Ferguson, a plumbing and HVAC distributor owned by a large British firm, recently announced the acquisition of a janitorial supplies distributor in Indiana. In turn, the company in Indiana acquired a shipping room suppliers distributor in Michigan. An example of a strategic combination is the 2013 acquisition of Barnes Distribution North America (BDNA) by MSC Industrial. MSC paid about $550 million for BDNA, a business with annual sales of around only $300 million and sluggish growth. BDNA s profits were in the $29-30 million range. Tax benefits and cost synergies helped analysts to understand the apparently very high price, but there s more than meets the eye. MSC wanted BNDA s large sales force, presence in Canada, integrated supply contracts and fastener expertise. This consolidation is a case of geographic expansion, product line extension, customer segment extension and sales method enhancement. Consolidation of Suppliers Some major suppliers to the distribution channel have been on an acquisition streak of their own. For example, Parker Hannifin Corporation sells many of its products lines through authorized distributors. Parker s numerous acquisitions of competitive manufacturers is disruptive to its traditional selective distribution patterns. 1 http://www.mdm.com/articles/32876-commentary-idgs-journey-to-sonepar?page=2

4 Effect of Consolidation on Trade Associations The membership roster of National Association of Wholesaler-Distributors (NAW) 2 includes about 100 national line-of-trade associations in the distribution industry. Examples are NAED (electrical distributors) and HARDI (heating and air conditioning distributors). Ongoing consolidation of trade association members affects the trade associations in several ways. As the member count drops off due to business combinations the associations may lose membership dues and fee income. One of the challenges is to create programming that is indispensable to both the large members as well as the smaller ones. Some associations have reached out to suppliers to become associate members in an effort to better meet the needs of the industry. As members add product lines they may find that their original trade association alone no longer meets all of their needs. They may choose to belong to multiple associations, potentially reducing their involvement in their traditional association. Effect of Consolidation on Buying Groups As the industry consolidated and large national distributors began to appear in the 1970s, independent distributors formed buying groups. The primary purpose of the groups was to leverage the buying power of the independents to obtain competitive pricing, rebates, freight, and cash terms from suppliers. Some of the buying groups also developed national accounts selling programs to enable members to compete for large contracts. Further consolidation is having a powerful impact on many of the buying groups. The loss of members through combinations, especially a larger member, dilutes the group s buying power. Some groups have reexamined their mission, and revisited their charter, to find ways to hold on to members following sale to a non-member or to a public company. As members add product lines they may feel the need to affiliate with additional buying groups to meet their overall sourcing needs. 2 http://www.naw.org/about/assoclist.php

5 Effect of Consolidation on Sales Function As described in the analysis of the acquisition of BNDA by MSC Industrial, in some business combinations one of the strategic benefits is the target company s sales method. In that instance the buyer strengthened its outside sales force. Grainger, a very large distributor who has grown in part through acquisitions, has developed multiple sales methods including a very strong electronic commerce function. MSC also has a very successful electronic commerce program. The role of the outside sales force in distribution is evolving from providing information and taking orders. These functions are being assumed by electronic commerce. Consolidation has accelerated this trend as distributors make acquisitions to speed the development of multichannel marketing: outside sales + proactive inside sales + reactive customer service + electronic commerce. Effect of Consolidation on Marketing As mentioned above, combining companies at the supplier level can upset existing selective distributor arrangements. The result is more and more distributors carrying lines that were previously sold only by a select group. Another phenomenon is the expansion of distributors, through consolidation, into previously unrelated product lines. The strategy of focusing on customer needs such as the one-stop shop examples of Interline Brands, Ferguson, and Sonepar has been accelerated by business combinations. Some of the larger distributors are investing heavily in private branding. The acquired company s brands are subject to conversion to a private brand. Effect of Consolidation on Information Technology Information technology is at the epicenter of consolidation challenges and opportunities. Distributors manage their businesses through their enterprise (ERP) software. A central objective in most acquisitions is to get the acquired business onto the same ERP platform as the acquirer. This objective works in favor of the more powerful and flexible systems typically run by larger distributors (buyers) at the expense of less capable ERP systems.

6 Effect of Consolidation on Human Resources Attracting and retaining Millennial talent, and the transition of baby boomers into retirement, are presenting tough challenges to distributors. Historically the distribution industry hasn t done an effective job in marketing career opportunities to young people. Business combinations are an opportunity to bring new talent into the acquirer s business. Larger organizations do a better job marketing themselves to college graduates and are able to articulate a clearer career path. Many smaller distributors don t have an effective HR function. Effect of Consolidation on Financial Performance The expression get bigger, get specialized or get out has been around for a long time. Very small distributors have a hard time generating a strong ROI (return in investment). If they don t have a special niche it s tough for them to offset low personnel productivity with high margins. Getting bigger isn t an obvious profit advantage unless we re talking about very big. Some of the very highest performance distributors are multi-billion dollar companies (Grainger, Fastenal). An incentive for business combinations is increasing ROI through higher personnel productivity, better asset utilization (receivables and inventory turnover), lower cost of capital and scale such as very powerful enterprise (ERP) software systems. As consultants, we foresee the continued success of super-regional distributors with 20-40 branches. These companies can be big enough to be meaningful to suppliers and to achieve scale (such as ERP), yet small enough to maintain customer intimacy and a strong, employeecentered culture. Effect of Consolidation on Exit Strategies Exit strategy is on the agenda for many owners of smaller distributors. The sale-minded owners are investing in their companies to make them more attractive to prospective buyers. This will continue so long as selling prices remain attractive, and as company owners move toward retirement age but have no ownership successors within the company. Call now to see how technology can help you navigate industry consolidation +1 770.882.0100

7 Recommendations 1. If your company is doing well, and you are thinking of selling, now is a good time to do so. 2. If your company is doing well, but you haven t done good estate and income tax planning, you probably have time to do so if you start now. 3. If your company is not doing well you should be working on strategic pricing and customer profitability. You need to start now. 4. If your company is affected by consolidation, and it almost certainly is, you should revisit your strategic plan to make needed changes. 5. If your buying group and trade association are important to your business you should become more involved in leadership to make sure you are well positioned. 6. If your enterprise (ERP) system isn t meeting your needs, now is a good time to update or replace it. At the very least you should not be more than one version behind the current one. About the Author Brent Grover Brent Grover founded Evergreen Consulting in 2001 as a boutique firm advising companies in the wholesale distribution channel exclusively. Brent is a Research Fellow at the NAW Institute for Distribution Excellence, faculty member at Case Western Reserve University and a board member at five companies. He is a CPA (inactive) and winner of the AICPA s Elijah Watt Sells Award. Brent was CEO and co-owner of a nationally known and highly innovative distributor (National Paper & Packaging Co.). He started his career in consulting at Arthur Andersen & Co. He has written nine books and many articles on distributor management. Brent also writes a weekly blog covering the latest trends in the distribution industry.

8 About I.B.I.S., Inc. I.B.I.S., Inc. is a premier Microsoft Dynamics Partner with over 26 years of experience implementing Microsoft Dynamics AX, GP, and CRM solutions along with Advanced Supply Chain Software for distributors and manufacturers. With four Microsoft Gold Competencies, including enterprise resource management (ERP), customer relationship management (CRM), business intelligence (BI), and application development, IBIS has the expertise to implement, customize, and support a wide range of Dynamics business applications. IBIS is a two-time winner of Microsoft Dynamics Outstanding Partner of the Year Award, the winner of Worldwide Partner of the Year Award for Microsoft Dynamics GP, a Worldwide Finalist for the Microsoft Dynamics AX Partner of the Year, a Microsoft Global Independent Software Vendor Certified for Microsoft Dynamics, and a ten-time Microsoft Dynamics Inner Circle Partner. IBIS is AMR Research Industry Certified in distribution and discrete manufacturing. About Advanced Supply Chain Software for Microsoft Dynamics AX Advanced Supply Chain Software for Microsoft Dynamics AX powered by IBIS is the leading supply chain management solution for distributors and manufacturers who want to optimize their supply chains for profitability. Fully embedded in Dynamics AX and designed in partnership with industry and supply chain experts, Advanced Supply Chain Software for Microsoft Dynamics AX is uniquely suited for the supply chain challenges of a new generation.