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The Consolidators Speak Out

The biggest consolidators in the business shared their expertise on the distribution market's sizzling acquisition climate in a unique panel discussion hosted by Brown Gibbons Lang & Co. in Boston last month.

Although Wall Street often overlooks slow-but-steady markets such as the wholesale-distribution industry in favor of investment opportunities in high-profile consumer segments like retail stores, banking and consumer electronics, distributor acquisitions were front-and-center at the 3rd Annual Cross-Border Conference, held May 8-9 in Boston.

Hosted by Brown Gibbons Lang & Co., Cleveland, the conference gave private-equity fund managers from around the globe insight into the inner workings of mergers and acquisitions during the wholesale-distribution market in the panel discussion, “Global Wholesale Distribution: Consolidating at an Accelerating Pace.”

Sitting on the panel were key players in mergers and acquisitions over the past few years: Peter Gotsch, partner, Code Hennessy & Simmons, Chicago; Thomas Ireland, operating partner, Clayton Dubilier & Rice (CD&R), New York; James McGibbon, director of strategic business development, The Home Depot, Atlanta; Larry Stoddard, senior vice president of business development, Wolseley plc, Theale, England; and Richard Worthy, chairman and CEO, U.S. Electrical Services, Chester Springs, Pa.

James Miller, managing director and principal, Brown Gibbons Lang & Co., says as a group the panelists had reviewed thousands of acquisitions in the wholesale-distribution business and invested in hundreds of distributors. The panelists agreed billions of dollars in private-equity capital has flowed into the wholesale-distribution business in the past 18 months and many deals are in the works.

“In 2005, there were three dozen deals done by private-equity firms or financial buyers in the wholesale-distribution market,” says Miller. “It's not slowing down. There were 10 deals in wholesale distribution done in the first quarter of 2006 by private-equity firms; in first quarter 2005 there were five. It's known as one of the hottest sectors certainly in the United States and maybe even the world right now.”

Peter Gotsch of Code Hennessy & Simmons sees “tremendous” opportunity for private-equity firms in the distribution sector. He says the public markets have turned significant attention to the distributor sector, and that they have valued companies in the public markets at very high multiples. “For small stuff of less than $50 million in transaction value, it's in the range of 6x to 7x EBITDA (earnings before interest, taxes, depreciation and amortization). The barometer has been set for the high-profile transactions at 11x, 12x 13x, EBITDA, etc.” (Editor's note: When Home Depot bought Hughes Supply, Orlando, Fla., it paid 11.8x EBITDA.)

Desirable Distribution

The panelists said the wholesale-distribution business has many attributes that attract investors, including its fragmented nature, the opportunity to increase profits with operational efficiencies and strong local management. CD&R has invested in the distribution industry for many years. Some of its larger deals include the purchase of WESCO from Westinghouse Electric Corp., Pittsburgh, in 1994, and more recently its investment in Rexel SA, where it's a lead investor. Together with Eurazeo and Merrill Lynch Global Private Equity, a CD&R-managed fund owns 73.5 percent of Rexel. CD&R's Thomas Ireland says private-equity firms like the fact that the distribution has thousands of suppliers, thousands of products and thousands of customers.

“There are interesting opportunities in consolidation and to expand geographies,” he says. “No one geography, customer or product can get you in a lot of trouble. It's an attractive investment opportunity.”

One company now making big-dollar investments in the wholesale-channel is Wolseley plc. Since August 2005, the company has spent approximately $1.3 billion acquiring 42 businesses in Europe and North America. These 42 acquisitions, which included at least one electrical distributor, D.S.I. Inc., a Las Vegas-based electrical supply house, are expected to eventually add approximately $2.1 billion to the company's annual sales.

Wolseley may not yet be a familiar company name in the electrical wholesaling industry, but the company is a dominant player in the plumbing, HVAC and building supply businesses, with its Ferguson and Stock Building Supply subsidiaries in North America. Globally, Wolseley plc has 63,000 employees in 14 countries. Larry Stoddard of Wolseley says because of the distribution industry's fragmented nature, it offers plenty of consolidation opportunities. He says private-equity firms also use their clout and financial acumen to eliminate waste in the distribution channel. He says although many smaller distributors don't have very efficient operating procedures, if they focus on the residential building market they are making money despite their inefficiencies.

“A little bit of slowness in the market will begin to weed out some of the players that operate inefficiently,” he says. “Some people who aren't great operators are having pretty good returns right now. That will slow down, especially if you specialize in the residential segment.”

Richard Worthy of U.S. Electrical Services says the distribution industry will offer consolidators higher earnings growth in the future because larger distributors will utilize some advantages that will come with size, such as sourcing inexpensive products from China or other low-cost providers and injecting best practices into businesses. “Logic says down the road distribution should have higher earnings growth,” he says. “People forget that most distribution industries are growth industries.”

James McGibbon of Home Depot agrees plenty of opportunities exists for savvy investors to run distribution businesses more efficiently. He says many of the senior managers at his company previously worked for GE, where they learned how to use Six Sigma management strategies and other best practices to create operational efficiencies. He says they plan to use these management philosophies to streamline operations and boost profits at the many distribution businesses (including Hughes Supply) now part of the Home Depot Supply division.

The healthy residential construction market has probably forced private-equity firms to pay higher multiples for companies, particularly if they are trying to establish a footprint in a market sector. “You need a footprint, and you pay what is necessary to get it,” says Larry Stoddard of Wolseley. “Once you have that infrastructure in place, it may not be as necessary to pay the high multiples.”

What Consolidators Want

Family-run supply houses can be popular acquisition targets if they offer a solid regional footprint, have no MIS (management information system) issues weighing them down, and are run by good managers who can continue to grow the business in their local markets. “If you have bad management and bad systems, you obviously have a bad company,” said Peter Gotsch of Code Hennessy & Simmons.

Worthy of U.S. Electrical Services agrees that good management is the most attractive element in a prospective acquisition target but added he is looking for companies that can dominate regional markets. He says this regional focus demands strong management and solid vendor relationships. “You must have an efficient business that marries the best customers to the manufacturers that you represent,” he says.

Home Depot's acquisition of Hughes Supply was a big topic of discussion at the panel, and panelists enjoyed teasing Home Depot's James McGibbon about the high earnings multiple (11.8x EBITDA) the company paid for Hughes. But the panelists say while they expect Home Depot to be a tough competitor, the company's entry into the market is actually a good thing because it forces other distributors to manage their businesses more efficiently and proves the wholesale-distribution world offers some solid investment opportunities.

Wolseley's Stoddard says because Home Depot has done a good job of promoting the products it stocks to consumers, it has increased buying activity for other companies, too. “That attention has elevated the amount of activity of consumer buying,” he says. “Several years ago, a homeowner would replace a faucet every seven years. That's down to every five years. If you sell faucets, that's a good thing.”

Peter Gotsch of Code Hennessy & Simmons says while some distributors may be afraid to compete with Home Depot, competition is healthy. “The good news about a high-profile, publicly traded company owning distribution is they want to get a return on those investments,” he says. “When a competitor wants to make money, you can compete with them based on service instead of based on price.

“As it relates to Home Depot, you have to go market-to-market. They are in eight or nine different levels of attack. There are some areas where it would be pretty difficult to try to compete with them. Other segments such as the electrical or plumbing sectors are too big and too fragmented to expect one, two or even three companies to dominate.”

Worthy of U.S. Electrical Services believes Home Depot's entry into the distribution world has helped some of its vendors adapt the best practices they have learned from Big Orange to other market sectors. “Home Depot has proved if they come up with a great process, manufacturers will go along,” he says. “There is always going to be competition. You want good competition. I don't see it as a negative.”

The Name Game

Private labeling will become a bigger factor, according to the panelists. McGibbon of Home Depot said it could be a “huge advantage” for distributors, and Wolseley's Stoddard says many large distributors will move to private labeling. He says in Wolseley's markets, privately-labeled products are in many cases “at least equal in quality and sometimes superior in quality to products made domestically.”

“I don't see a lot of exclusivity in branded products,” Stoddard says. “If you are a manufacturer, you must identify the low-cost positions. You have to be able to compete. As the industry becomes increasingly consolidated in plumbing, HVAC and electrical, you are going to see some of the big distributors start taking on brands.”

Richard Worthy says as a new company U.S. Electrical Services doesn't yet have the critical mass to utilize private labeling, but he agreed it's here to stay. He says because relatively few electrical manufacturers are known for their product innovation, their brands can be susceptible to private labeling.

“It's just a natural curve where we are migrating down to where a lot of these products are commoditized,” he says. “It gets emotional, but at the end of the day natural market dynamics are taking place in our industry. Distributors used to be logistics companies, but now they have to see themselves as marketing companies. Customers will define the distributor's role.”

When it comes down to the actual sale of a company, the panelists agreed sellers are getting more sophisticated and that most rely on advisors to guide them through the selling process. “Even the smallest, least-sophisticated sellers know to call some kind of advisor,” says Home Depot's James McGibbon. “It's very unusual now to negotiate directly with the seller.”

Worthy says while it's important for sellers to use experienced law firms, it's absolutely critical for them to use blue-chip advisors. “The market is going to set the price,” he says. “You want objectivity. That's hard to do without an advisor.”

Merger and acquisition activity in the wholesale-distribution world seems to go in cycles. The panelists agreed the combination of willing sellers who want to cash out of their businesses, willing buyers backed by private-equity funds and a healthy economy have created the perfect climate for many more deals in the very near future.

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