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Should Distributors Sell, Buy, Merge or Hold their Businesses in 2010?

Now may be a good time for distributors to sell their companies or buy others.  However, there are very important conditions to be considered in moving ahead with an acquisition or divestiture strategy in 2010.
In preparing this newsletter we had the opportunity to speak with three very knowledgeable professionals in distribution generally and mergers/acquisitions specifically. 

Chuck Andrews of The McLean Group
(Investment Bankers)  

Terry Kennedy of Meltzer, Purtill & Stelle LLC
(M&A Transaction Attorneys) 

Jack Keough of Keough Business Communications
(Former Editor and Publisher of Industrial Distribution Magazine)
We, at The Distributor Board, want to thank them for their time and insights.
Is now the time for a transaction? As always "it depends." It depends on:

  • The performance of your company
  • Conditions in the general market
  • Conditions in your vertical market
  • Availability of buyers
  • Availability of sellers
  • Realistic valuation expectations
  • Your motivations with regards to exit or expansion
  • Buyer financing capability

To begin addressing these questions one must put the distribution market environment into perspective.  Without a doubt, conditions are turning from very bad to better.

  • Employment is improving, because job loses are lessening, however, the rate of unemployment remains high.  There has been a 7% decline in overall distribution employment with the following verticals experiencing the steepest declines - Building materials, Furniture, Computer equipment and Plumbing.(according to a report titled "2010 Economic Outlook for Wholesale Distributors," by Pembroke Consulting Inc. and IBM) Link to Article 
  • Wholesale inventories are down significantly since the start of 2007 and only beginning to build back as manufacturing starts to improve.  In raw numbers inventories are down almost 15% as compared to 2007 figures. 
  • According to the ISM New Orders index, business appears to be improving.  From a decline of -35% they are seeing an improvement of +5% in the number of new orders. 
  • We have seen steep declines in GDP during 2009, however, most forecasts are indicating improved comparisons in 2010. Unfortunately, this is due mainly to the overall poor performance in 2009.  GDP is expected to improve by approximately 2% in 2010 according to the Bureau of Economic Analysis, Wells Fargo Bank and the McLean Group report. 

Within this somewhat improving environment, the value of distribution companies will increase. In a recent Modern Distribution Management Report, the value of "public" distribution companies has come back.   In looking at the most recent historical data, the high value mark was in 2006 at 13.3x the Median Enterprise Value/EBITDA and the low level was 5.9x in the first quarter of 2009.  Recently, this has returned to a 10.0x in this quarter. 
These do not reflect what small and middle market distributors can expect for valuation, which has typically run in the range of 3-5x EBITA. However, if private market valuation trends follow, it can be expected that at or near the bottom EBITDA multiples may have been as low as < 1x to 1x. Currently one would expect an improvement, but probably not back to historic trends.
In a recent report by Hinge Marketing, in their "Top Dollar" report Link to Article , they talk about the Factors Driving Premium Values for professional service firms. We believe that these same factors are accurate for the wholesale distribution sector:
Rank   AR*      Factor 

1     8.39     Strength of Existing Client Relationships
2     8.00     Technology
3     7.86     Quality of Management Team
4     7.51     Marketing Strategy
5     7.21     Financials
6     6.89     Employees 
7     6.28     Profile / Image

*Average Rating.  0-10 scale where 10 is most important to obtaining a premium value
An important take away is the focus on your customers.  Have they stayed solid throughout the downturn?  Are they growing?  Is your relationship with them growing?
Although "Employees" are lower on the list, among those we interviewed, not enough could be said about the importance of employees in the valuation of a company. In particular, sales people, who hold the important customer relationships, are viewed as "intrinsically important" to the business.
Among those we interviewed, there seems to be consensus on the fact that business buyers do exist, however, the "strategic" buyers will have a greater chance of being successful in the short term. Why is this true? The main reason is that financial buyers, private equity firms and individual investors, will have to provide much higher levels of equity than ever before. In the past financial buyers relied on a heavy leverage component for a transaction. The banks today will not support this type of leverage, at least in the near term. Strategic buyers, in many cases, are sitting on high levels of cash and can create improved financial performance from a combination of entities. Now seems to be an opportune time for a strategic buyer to grab share at lower acquisition prices.  According to Thomas Gale of Modern Distribution Management, 

"...sellers are not likely to have the number of potential buyers courting them - at least for a while - as financial buyers (private equity funds and other outside investors) don't have the same flexibility because of current credit rates and conditions." 

However, opportunities may exist among strategic companies in your vertical market where there are synergistic combinations that provide improved performance and competitive advantage. But, there are fewer of these today due to past consolidations and the economic demise of marginal distributors.
Historically, banks have looked at assets as an important security in both lending and business combination transactions. At a recent meeting one banker stood up and said "assets are less important ... cash flow is what we look at today." What he further went on to say is that if a deal goes bad, the bank has many less avenues in which to sell the assets. This is very much different than in the past. In the past, many loans were leveraged against assets. The reality today is that these same assets' values are under water. This is particularly true in the current market with regard to real estate, equipment and inventories. On the other hand, if a company performs well, cash flow will follow. If they do not, the assets will most likely not support the underlying lending. This is a radically different lending philosophy as from the past and may be a vision for the future of the credit markets.
Transactions are not always rational decisions.  Owners may be "burned out" on the business.  There may be marital or other family issues.  Estate conditions may drive decisions.  The owner's physical condition may demand a change of ownership.  Interestingly our panel does not feel that taxes drive the decision process.  However, this may change as future estate tax laws are determined in Congress.
What we conclude from current conditions are the following:

  • If there are not any compelling conditions for selling your business, it may be better to wait for a more improved economy and better valuations.  However, if your performance has been great during this recession and you are "best in class" you may find very willing suitors with a lot of cash and a lot of interest. 
  • If you see an opportunity to buy a competitor, or expand into another product line through acquisition, now may be a better time than ever to make a move.  The costs of making this move will most likely only go up as we pull out of this recession.

An important final consideration is integration.  It has been stated that over 70% of all acquisitions fail.  This is very often due to badly managed integration of the entities.  As you consider a critical event of this nature, invest adequate time planning what will happen after the deal.

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