The long-awaited economic recovery does seem to be taking hold at last. With the rise in expected sales volume comes an improvement in prospects for electrical distributors, even in the areas hit hardest by the downturn. The improvement enhances valuations for owners of companies interested in exploring a sale.
For this reason, many specialists in mergers and acquisitions in the electrical industry expect to see an increase in deals among distributors toward the end of 2011, throughout 2012 and into 2013. The action has already begun on the manufacturer side, with some large deals announced in late 2010 and the first part of 2011, and there's also been quite a bit of activity among industrial distributors, but the electrical distribution market has been relatively quiet, with a handful deals in the lower mid-market range - most of them incremental add-ons in geography or product specialty. The M&A people don't expect things to stay quiet much longer. They cite a number of reasons why we should hang on for a significant round of consolidation among electrical distributors.
Since the economy began to founder in 2008, most companies have kept their money to themselves rather than invest in expansions and hiring, waiting until there's more solid evidence of a rebound that would boost demand for their products. Meanwhile, actions by central banks to keep interest rates low to stimulate the economy have made financing for deals more attractive.
The rise in the stock market and the whiff of economic recovery in the air has investors who had socked away money in safe-havens to ride out the storms of the past few years ready to move into investments with higher risk profiles and higher potential returns.
These factors explain part of the increase seen recently in manufacturer mergers and acquisitions, says Anthony Kure, equity research analyst with KeyBanc Capital Markets, Cleveland.
“I think activity is higher than normal now due to the very strong rebound in earnings and cash generation (among publicly traded companies) combined with historically low interest rates,” Kure says. “Together these two factors have, for the stronger players, yielded very strong balance sheets with historically low leverage ratios.”
A large part of the expected activity will involve private equity (PE) firms. In the not-so-distant past, PEs had a minimal role in the electrical distribution market, as they were hard-pressed to match the prices a strategic buyer would be willing to pay. But that began to change a decade or so ago and now they play a pivotal role in the consolidation of the electrical distribution market.
PE firms are active on both the buy side and the sell side. Since PE firms typically retain ownership of a company for a certain number of years — a five-year investment is pretty typical — and they've stayed out of the market for the past two to three years while valuations troughed, there are a number of them looking now to divest some of their distribution holdings as soon as the valuations are favorable.
With the economy coming back, PE firms are rejoining the game, and they have some serious money to work with. By some estimates, there's about $1 trillion (yes, that's a “t”), in private-equity money available for investment — about $500 billion in funds that can be leveraged on at least a one-to-one, debt-to-equity basis. (Note, we're talking worldwide economy here, not just electrical or distribution.)
Strategic acquirers such as large distributors looking to extend their reach, meanwhile, find themselves in a strong cash position, with the funds to support acquisitions. Some publicly traded distributors have made growth through acquisition an explicit part of their growth strategy, so shareholders and analysts will be watching for them to execute on this plan. These companies, our M&A specialists say, have been hard at work investigating potential acquisitions, even while waiting for more clarity on the course of the economic recovery.
“In MRO, you've got some of the larger distributors announcing that they're building-up their in-house M&A teams and stating publicly that they would like to make acquisitions,” says Jason Kliewer of investment bank Robert W. Baird & Co. “Similarly, larger electrical distributors, such as Rexel, Sonepar and WESCO, have increased their focus on acquisitions. Strategics are interested, it's just about timing and when the sellers are ready to sell.” Baird's overall backlog of M&A deals in the works is at record levels right now, he says.
Benefits of Bigness
For independent distributors, resisting the overtures of acquisition-minded competitors and national chains has long been a point of fierce pride. Electrical distribution by its nature is a local-market game, where a company may have all the nationwide branding clout and economies of scale anyone could want, but any given branch will get its lunch eaten every day by a local independent if its service levels aren't up to snuff.
And yet, depending on an owner's long-term motivations, there are compelling arguments for joining a large-scale organization. Economies of scale have always given large chain distributors benefits in terms of buying at lower costt on better terms. Independent distributors have sought to counter this advantage through buying groups, but these still involve multiple orders to multiple companies with varying market positions, service offerings, support needs and risk profiles, making it hard to truly match the efficiencies of selling the same volume to a single distributor.
At the same time, a number of other trends are adding to the benefits of scale. One of the most critical is the growing importance of technology in distribution. The back-end enterprise resource planning (ERP) systems on which distributors run their businesses are increasingly a source of competitive advantage, and it's hard for a smaller distributor to match the staffing required to fully exploit the capabilities of any given ERP system and all the sales, inventory, operations and financial data it produces — not to mention the burden of monitoring and managing the inflow and maintenance of manufacturers' product and pricing data.
(Notice, too, that distributors' ERP vendors are also busy merging and acquiring in search of their own economies of scale to support further R&D (and private equity returns). In the past two months there have been two deals, worth about $2 billion each, involving the two biggest names in electrical distributor ERP systems: Activant Solutions, Livermore, Calif., and Epicor were acquired by the same PE firm and will be merged under the Epicor name. Infor, Atlanta, shortly thereafter announced that its primary financier, GGC Software Holdings, acquired Lawson Software with explicit intentions to merge the companies' ERP system development paths. )
Out front, on the customer-interface end of things, the same phenomenon separates distributors in their ability to offer electronic commerce platforms where customers can buy the way they want and link their purchasing systems with key suppliers, all of which requires yet more staff to design, develop and manage these interfaces.
Beyond the information technology considerations, the advantages of a large distributor in terms of market diversification by geography or product category, nationwide or region-wide service offerings and career advancement opportunities draw talent and spread costs and market risk over a broader revenue base.
All that said, we're not seeing much merger and acquisition activity in the electrical distributor market. Industrial distributor deals are getting done. Manufacturer deals are getting done. Why not electrical? The short answer is that it's not time yet. Some of the industry's M&A specialists expect that to change over the next few months.
Why the Wait?
Kliewer of Baird says MRO distributors have been quicker to return to pre-recession — circa 2008 — levels of revenue, mostly due to their exposure to the manufacturing sector, which rebounded strongly coming out of the downturn. Publicly traded industrial distributors in general saw earnings before interest, taxes, depreciation and amortization (EBITDA) drop by around a third in 2009, but their operating cash flow was up a third due to the decrease in working capital, specifically reductions in inventory and receivables, according to a recent Baird report on industrial distribution M&A.
“In the electrical space, a lot of companies got hit pretty hard in 2009, as many have exposure to commercial and residential construction. They've had to manage through weakness in those end markets, which tend to lag a broader economic recovery, plus the general economic downturn, so it will take longer for the electrical distributors to get back to their peak revenue. That said, leading electrical distributors are now firmly on a growth trajectory. In the case of (industrial distribution giants) Grainger and Fastenal, they're all already back to their peak 2008 revenue,” Kliewer says.
“It's still a very fragmented industry, and there are a number of electrical distributors of good size that would be of interest to both strategic buyers and private equity. However, for electrical distributors with significant exposure to the commercial and residential construction cycle, I think it's just a question of timing and where we are in the cycle that makes it harder for valuations to meet between buyer and seller,” he says.
On the manufacturer side, it's a different story and M&A activity already is picking up, as you can read further in the companion piece “They Must Be Giants,” page 20.
The difference there is in the way manufacturers generate cash, says Kure of KeyBanc. “In my view, manufacturers have more cash generation capability versus distributors in an accelerating demand environment. From what I've seen distributors tend to use cash to ramp up inventory levels and may even be using more cash than they are generating at this point in the cycle,” Kure says.
Timing is Everything
So, when will the “fun” begin? Distributors looking to sell will find the best deals over the next two years, says George Spilka of George Spilka & Associates, Allison Park, Pa., an independent M&A advisory firm focused on mid-market distribution companies. Spilka is placing his bets on a return to global recession after 2013, based on his reading of macroeconomic fundamentals including the continuing liability of “too big to fail” financial companies (having grown even bigger), taking excessive risks with the certainty they'll be bailed out. But he's confident the economy, with support from the Federal Reserve, if necessary, will continue to be strong through the elections in 2012. Along the way, prices paid for businesses will improve, he says.
Other M&A specialists, though less willing to give their read on the overall economy's prospects years out, similarly expect consolidation activity to increase substantially in the second half of 2011 and continue to be strong for a couple of years.
Though M&A activity in electrical distribution remains muted, there hasn't been a complete absence of deals being made. Most of them have been tightly focused, strategic moves by the acquirers to gain breadth in specialty markets or geographic territories. Of the various niche markets in the electrical industry, industrial automation, utility infrastructure around the deployment of a smart grid, and specialties in energy efficiency and renewables have drawn the most interest.
Early in the year, Elliott Electric Supply, Nacogdoches, Texas, bought two locations in Springdale and Fort Smith, Ark., from Treadway Electric Co., which were geographic add-ons to Elliott's 108-location branch network, plus one-house Houston distributor Key Electrical Supply.
In March, WESCO International Inc., Pittsburgh, acquired RECO LLC, Cincinnati, Ohio, a Siemens automation, controls and electrical distributor with annual sales of approximately $25 million and six branches in the Midwest and South. The purchase was an add-on to WESCO's growing presence in factory automation nationwide. It followed a much larger deal in Nov. 2010 to buy TVC Communications, Annville, Pa., a data-communications distributor with annual sales of about $300 million, from private-equity firm Palisades Associates.
In June 2010, Kaman Industrial Technologies Corp., Windsor, Conn., bought Minarik Corp., Glendale, Calif., to create a distribution juggernaut in the factory automation space, combining Kaman's extensive power transmission presence with Minarik's lead position in motion control. Last month, they added geographic coverage, buying the assets of Automation Technology, Inc., Boise, Idaho, which also has a location in Salt Lake City. This move expands Kaman/Minarik's presence in the Intermountain and Pacific Northwest trading areas already served by Minarik locations in Portland, Seattle and Denver.
What ultimately interests strategic acquirers is the hope of finding well-run distributors with an established track record of providing innovative services that add to sales to existing customers, particularly in the area of energy efficiency. “They are looking for companies that provide a service for the same customers they sell product to today, so they can do more for those customers. But they still want to have the option to sell product,” Kliewer says. “For example, a very high-touch, solutions-oriented distributor — if they have the ability to go into a plant and make that plant more energy efficient, then also sell the product to help the customer solve a problem, that's of interest to these guys.”
Show Me the Money
What all this means, for an electrical distributor interested in selling a company, is that willing buyers are out there and activity is picking up, but they will need some convincing from anyone trying to justify multiples in the higher end of the prevailing range.
Valuations depend on all kinds of variables relating to a company's size, health, market position and the strategic intentions of the buyer, but multiples commonly seen in deals for companies over $100 million fall roughly in the range of 8 to 10 times EBITDA.
“Multiples have actually been a constraint to even higher levels of M&A activity,” said Kure of KeyBanc in an e-mail exchange. “I have heard from several of the publicly traded companies I follow that expectations among many targeted acquisitions are still unreasonably high, which is causing some level of frustration among those looking to buy. During the recession, acquisition targets tended to use trailing 12 months financials (i.e. before the recession) to value their business but now they are using forward 12 months projections. In both cases, there still seems to be unreasonably high price expectations for sought-after firms. Bottom line: companies want to consummate more transactions but aren't willing to overpay.”
The kinds of multiples paid for middle-market businesses generally are beginning to rise, according to Baird's Global M&A Monthly Report for March, which showed average middle-market valuations rising year-to-year from multiples of 8.6 times EBITDA to 9x over a trailing 12-month period, amid a contraction of almost 25 percent in the total number of middle-market deals. The same report showed the number of deals valued over $100 million rising over 29 percent while those below the $100 million threshold fell almost 21 percent and the total dollar volume surged 39 percent.
For the industry as a whole, the economic recovery, the revival of private equity firms' interest in making deals and the improvement in the balance sheets of public companies all means we may be in for substantial realignment among manufacturers and distributors in the electrical industry. Whether your company is at the table or not, please take your seats, the consolidation show, it seems, is about to begin.