Through August 2005, auto aftermarket mergers and acquisitions in the wholesale and retail segments, including parts and services, continued to run strong, just as they have for more than a decade. Through the end of August, they were up some 30 percent over the same period last year.
Even though M&A transactions continue, the underlying currents reflect how the industry is reshaping itself and what organizations should know as they plan to sell or acquire in the near future.
First, a little history: In the early 1990s, the aftermarket industry was highly fragmented. In 1993, for example, there were only eight major acquisitions. Then, as conditions improved, the benefits of combinations became compelling. Throughout the 1990s, consolidation became commonplace. At its peak in 1999, there were 33 M&A deals in aftermarket distribution.
Initially, the retail side of the industry was the focus of the consolidation wave, and it hit a peak in 1998 when it accounted for 76 percent of aftermarket distribution transactions. Now, that phenomenon has slowed, with only 10 percent of transactions in 2004 and 2005 in the retail parts space.
Forty percent of the industry has consolidated in the top 20 players, and attention has turned to the wholesale side, which is much earlier in the consolidation cycle. Only 11 percent of the wholesale side has merged, leaving many possible marriage candidates available and an outlook that predicts a number of consolidations to come. As a result, over 65 percent of merger transactions in 2004 to 2005 were wholesale related.
Wholesale business is, in many ways, more attractive than its retail brethren. It is a larger market, growing faster than retail, and generally has higher margins.
One result is that most major retailers want to participate on the wholesale side. But making a retail-wholesale combination work is not easy due to many structural differences.
Retail stores can’t carry broad enough inventories and aren’t typically replenished frequently enough to provide the high fill rates required in the wholesale world. They also aren’t designed to have enough warehouse space to carry the necessary inventory.
Extraordinary levels of service are required as a jobber, including a fleet of delivery vans, which is a difficult model for a mass retailer to master. Furthermore, wholesale customers demand highly trained, well-paid store personnel, which are too expensive for the retail model.
Bridging the two business models is rare, but O’Reilly is one company that has mastered a hybrid strategy, with about 50 percent of its sales commercial.
Goldsmith Agio Helms advised Mid-west Auto in this year’s Midwest Auto/ O’Reilly Auto Parts transaction, which worked because both O’Reilly and Mid-west shared very similar hybrid business models. Other-wise, it appears that the large retail gorillas will have a difficult time competing with the more focused wholesale players.
Furthermore, it is unlikely that a retailer will acquire their way into the wholesale side — the wholesale systems are too incompatible with their existing operations.
What wholesalers look for in a merger
We expect most of the merger activity to be wholesale-to-wholesale, including hybrid wholesale/retail operations.
Prospective buyers evaluate a handful of criteria. Growing market share is always the bottom line consideration, in order to achieve greater purchasing power and deeper market penetration for more efficient sales and marketing.
However, these are the specific considerations that buyers use to select a company to acquire and that sellers should use to predict if the transaction is the right fit:
Geographic adjacency. Large WDs want to grow in contiguous territories to make efficient use of existing distribution centers. Such adjacency often allows buyers to consolidate DCs, typically saving millions of dollars per year. Geographic adjacency also allows the buyer to optimize sales and marketing expenditures and build customer loyalty more efficiently in target markets.
Company stores. There is a trend toward company-owned jobber stores, away from the traditional WD that serves hundreds of independent jobbers. While this strategy requires more investment in inventory and intensive jobber-store management, it provides the wholesaler with more control of market share and a small increase in margin. For example, Uni-Select is moving from its traditional independent-jobber model as reflected by its acquisition of MAWDI (Middle Atlantic Warehouse Distributors) in 2004. We expect to see a wave of acquisitions of independent jobbers by their master distributors over the next 10 years.
Purchasing savings. Large wholesalers have such high volumes that their purchasing power results in a gross margin that can be 5 to 10 percent higher than an acquisition. As a result, an acquisition of a $50 million sales company could result in $2.5 million of annual savings to the buyer from purchasing alone.
Personnel issues. Buyers typically keep most of the employees of the seller’s business post-transaction. If the buyer is a major aftermarket retailer or wholesaler, they may not need certain top executives. Those executives are usually protected by severance agreements, so when they are asked to leave, they are compensated for having to find new jobs. In the event of a warehouse closing, many more jobs are at stake, and the seller and buyer should cooperate to find jobs for displaced workers.
Product compatibility. Inventory is of major concern to potential buyers. If it’s not compatible — for example, the buyer and seller stock competing brands — the buyer must weigh the cost of a full replacement of inventory for the long-term and a discount of existing SKUs for the short-term.
Intensifying the issue is the potential disruption to a jobber and/or installer client base that must make the transition to different parts. Product incompatibility is often exacerbated since most wholesale distributors belong to a buying consortium. These program groups focus on certain vendors to the exclusion of others. Therefore, it is generally a much less painful process for a buyer to acquire a seller that purchases inventory from the same buying group. In the case of Midwest Auto and O’Reilly, both were in the Aftermarket Auto Parts Alliance, mitigating this issue. However, there were product incompatibility challenges with other interested buyers who purchased parts from other buying groups, which diminished value in their calculations.
Value is based on earnings and book value.
Valuations of aftermarket transactions vary widely based on a number of criteria. A buyer will want to acquire for less than its own public valuation metrics to yield an accretive transaction. Buyers look hard at book value — many transactions reflect book value plus some amount of goodwill. However, values are increasingly based on earnings, and a buyer will consider growth and consistency of sales and earnings and potential cost-savings, and weigh these against the negative effects of potentially losing customers in the transition.
Valuations for most aftermarket acquisitions in 2004 and 2005 where valuation was disclosed ranged from 6 to 7 times the most recent 12-month EBITDA (earnings before interest, taxes, depreciation and amortization). Where there were large potential cost savings or major strategic opportunities, valuations were above the high end of that range.
We believe it is inevitable that the wholesale aftermarket will consolidate rapidly through acquisitions and market build-out. This will put smaller businesses with higher cost structures at a competitive disadvantage, and will increase the pressure on the smaller players to sell before losing serious market share to larger players.
Successful transactions require that the buyer first establish a strategic purpose and find a compatible candidate where there are cost-saving synergies. There are many such merger candidates in the industry and ideal strategic partners for most. As a result, we believe we’ve seen just the beginning of a wave of consolidation in the wholesale sector.
