Digesting double digit EBITDA multiples in the merchant wholesaler industry

by Scott Benfield and Steve Griffith

The authors contend that the recent EBITDA multiples of 10x and 12x, for distribution businesses, may be a way of the future. However, the buyers will need plenty of savoir-faire in cost reduction, pricing management and well planned human capital redeployment to make the numbers work. Changing the organizations to reflect the new realities will be difficult. Many will fail.

In the recent acquisition spree for merchant-wholesalers, valuation multiples have skyrocketed. Starting with the 10x EBITDA multiple paid by Sonepar for the Stuart Irby Company and followed by the 12x multiple paid by Home Depot Supply for Hughes Supply, the historic multiples of 6x to 8x, of the recent past, appear quaint.1

With premiums of 30 percent or more being offered over historic, intra-industry deals, the seminal questions are: Does this increase make financial sense and how will buyers make the numbers work?

Our research and work in merchant wholesale markets finds that suitors with deep pockets may indeed make the math work on the historically high acquisition prices. However, they will need great skill and advanced knowledge in the areas of reducing solicitation costs, capturing value with better pricing, recruiting better leaders, and maintaining service quality with better organizational change techniques. We devote the rest of this paper to supporting our theories on the key ingredients needed to make the double digit multiples work.

It’s an old business model with falling fundamentals and third generation managers
Wholesale distribution is a century-old business that blossomed with the Industrial Revolution. Manufacturers needed an economic means of getting parts to market and distributors offered a place close to the market, extension of credit to industrial buyers, and a warehouse to store, break, and aggregate bulk products.

As the business matured, the products commoditized, and capital returns began to fall precipitously. Starting in the 1970s, return on net worth declined from 20 percent to approximately 10 percent by the new millennium.2

Industry specific acquisition began at a brisk pace in the 1980s and was, in part, due to the falling capital returns. Along with falling capital returns, we have found that productivity, as measured in sales per employee, has stalled for the last decade or more for merchant wholesalers in the durable goods sector.3

Depending on the sector, many durable goods vertical markets had over 70 percent of their members fail to earn a market return of 11 percent on investment by 2004.4

As if the financial trends weren’t worrisome enough, the generational ownership trends will, if parallel industries are any guide, cause nine out of 10 businesses to sell out or implode as they near the third generation.5

The majority of distribution businesses are in their third or late second generation. In addition, while many have been acquired, the vast majority of the slightly less than 300,000 distribution entities are family owned, small, and run by a second or third generation blood relative.

The synthesis of the financial and generation trends, on the surface, make an acquisitive strategy questionable. Unless the acquirer substantially changes operations, inclusive of reducing and leveraging costs, the acquisition into an industry with falling fundamentals and leagues of third generation owners makes little sense. We have noted, on numerous occasions, that wholesale distribution is a notoriously difficult business to scale based on its conventional financial structure. The capital structure of distribution has perennially lower fixed costs than manufacturing and roughly two-thirds of all costs are for salaries and people who offer service to the customer. Outsiders, at the 40,000 foot level, cite that roll-ups will gain a competitive advantage as larger entities can leverage supplier relationships where cost of goods are 75 percent of the sales revenue. However, industry insiders counter that the vast majority of smaller wholesalers are members of co-op buying groups, leverage proprietary volume, and purchase at a comparable price to the large firms. Hence, with a low fixed cost base, our belief is that lasting cost advantage will take place primarily by redefinition and streamlining of processes.

Historically, intra-industry acquisitions have involved leveraging the rote services of purchasing, accounting, warehousing and shipping. These back door services, while important, are limited in their ability to offer cost concessions. At some point, the acquirer hurts customer service and asset management if these functions are stretched too thin. As the multiples rise, however, we believe front door costs will become the focus for leverage including sales. We also believe that the front door function of pricing, or capturing value, will become more controlled by marketing and operations, versus the largely cost-plus pricing used by sellers.

The table below depicts the various functions and the focus for financial improvement needed to support higher acquisition multiples.

The acquisitive model, in short, will change from gaining leverage on back-door functions to redefining and reducing costs on front-door functions. Some of the back door functions may be outsourced and the front door function of sales will be redefined using new models of deployment, alignment of sales with growth opportunities, and supplanting high cost of service sales with cataloging and e-commerce.

Redefining the sales culture and moving from selling to solicitation
Approximately 30 percent to 40 percent of distributor operating expenses are sales related. Typical costs for outside sales range from 3 percent to 5 percent of revenues and inside sales range from 2 percent to 4 percent of revenues. With operating expenses running 18 percent to 21 percent of sales, the sales cost component is the largest single bucket of operating expenses.

Wholesaling is largely a sales culture. Sellers are familiar with products, their sources, and discreet customer needs. However, selling as it has been traditionally approached, is largely inefficient and in need of streamlining.

In our 2006 release, Restructuring the Distribution Sales Effort, 6 we documented the following inefficiencies in distributor sales forces including:

• Margin dollar bonuses and commissions that reward sellers for any and all margin producing accounts including those that historically produce negative activity profits

• Geographic sales allocations that drive volume instead of profits and place the firm in questionable segments where they are at a competitive disadvantage

• Sales control of pricing where the seller “auction prices” with cost plus pricing behavior

• A service arms race where unique services are promised by sellers to differentiate commodity offerings with the result that the services raise operating expenses but are not included and priced in the cost of material goods.

These behaviors are ultimately profit destroying and are cause, in part, for the declining profit picture in much of durable goods distribution.

In two separate surveys, we have questioned end-user customers on the financial value delivered by outside and inside sellers vs, their costs. When the customer is offered a price decrease commensurate with sales costs, the majority elects to order via catalog and fax or e-commerce.

While this type of service cost unbundling is radical thinking to existing distribution executives, it is not unnoticed by outside industry buyers who, from our experience, are investing in lower cost solicitation and transaction techniques including cataloging and e-commerce.

Based on our experience in restructuring sales efforts in distributed markets, it is not uncommon to take 20 percent to 30 percent out of sales functions by better territorial alignment and using queuing technology and process mapping for inside sales functions. Further cost reductions are possible if management uses newer sales models of enterprise, functional and segment sellers vs. the geographic modeling that is inherently inefficient.

Whether existing distributors will adopt new techniques of sales deployment is unknown. Most distribution is sales-driven and sales-dominated executives have a hard time understanding why sales costs and sales structures are inefficient.

Outside buyers who are not steeped in the sales culture, have an advantage in that they don’t see sales forces as any more or less valuable than other functions. And, if they conclude that distribution selling is overstaffed and inefficient, they will seek ways to reduce their costs while maintaining service quality.

Pricing gains and sustaining the momentum
Pricing, as a potential for gain, was largely unexplored in distribution until the last decade. Our book, Pricing Management: Capturing Value for Distributors,7 was the first of its kind in distribution six years ago. Today there are numerous pricing consultancies courting the distribution market with customized consulting and software solutions.

From our perspective, pricing has the potential, in sales driven distribution companies, to increase operating profits 30 percent or more without negatively impacting sales volume. Most distribution pricing is cost plus and highly reactive. Most sellers control pricing and suffer from behavioral pricing impediments including Prospect Theory and the Upper Limit Theorem. The old saw, if you want to price consistently in distribution, is the two-finger pricing rule. The first finger is cost plus 20 percent and the next finger is cost plus 15 percent. Pricing in distribution is, based on our research and recommendations, inherently complex and real pricing gain, with a chance of sustainability, takes a year or more to develop.

Price sensitivity can vary by type of transaction, segment, customer size, buying situation, and geography. For consistent and manageable pricing to take place, pricing modules, embedded in the ERP software require substantial change. Most pricing software is simplistic and captures limited marketing variables to help make the pricing decision. Many distributors try coaching and sensitivity training for sellers on pricing but these “inspection” systems have limited effect as they are mitigated by behavioral pricing factors.

Distribution, by most accounts, is a decade away from widespread adoption of professional pricing practices. Progressive distributors have funded the discipline with pricing managers and divorced much of the cost-plus pricing from the sales force.

As in the need for sales-cost streamlining, the sales culture often limits pricing gain. Pricing professionals, however, eschew sales-driven pricing and, with support, can give their employer substantial operating profit increases.

To secure pricing profits, the cultural change involves moving from a sales culture to a more balanced firm that engages marketing and operations with equal power to drive results. Outside the industry acquirers, as previously noted, don’t come with cultural biases for sales driven pricing and are more likely to use professionals to develop the function.

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Scott Benfield is President of Benfield Consulting of Chicago and specializes in Distribution and Industrial Channels. He has a BA and MBA from Wake Forest University and can be reached at (630)-428-9311 or at www.benfieldconsulting.com.

Steve Griffith is President of Merrimont Group LLC of Dayton, OH specializing in industrial channels and organizational change. He has a BS in Engineering from Purdue University/MBA from the University of South Dakota and is a Doctoral Student in Organizational Leadership at Indiana Wesleyan University. He also serves as an adjunct faculty member, teaching graduate business courses. He can be reached at (937)-470-7136 or at www.merrimont.com.

1 Funk, (Feb. 1, 2006) Big Orange Hits Home, Electrical Wholesaling, and Brown Gibbons Lang & Company (October 3, 2005),  Brown Gibbons Lang & Company Sells Stuart C. Irby Company to Sonepar USA, Press Release.

2 Sullivan and White, (Sept. 2004), Four Decades of Distribution, TED Magazine, page 107.

3 Benfield, Productivity and Profit Issues in Durable Goods Distribution,(December 2004) White Paper, Benfield Consulting, at www.benfieldconsulting.com/benfield_site/WhitePaper1.htm.

4 Benfield Consulting research with Association PAR reports for Industrial Products and Contractor based industries.

5 Success of Succession,” (March 2006) All Business at allbusiness.com,  page 1.

6 Benfield and Vurva, (2006) Restructuring the Distribution Sales Effort,  Brownbooks Publishing, Dallas.

7 Benfield and Baynard, Pricing Management: Capturing Value for Distributors, 2000, LNC Press.