HD Supply Begins to Unroll-Up

HD Supply has reportedly begun the un-roll-up (roll-down?) process.

The Home Channel News is reporting that HD Supply has agreed to sell its Lumber and Building Materials (LBM) unit to Pro-Build Holdings Inc. Modern Distribution Management estimates that the two largest companies in the division had combined sales of almost $800 million when they were acquired in 2005 and 2006. Total revenues in HD Supply’s LBM are surely lower today given the pressures that I highlighted a few months ago in The Fallout from HD Supply.

I’m sure HD Supply (and its new owners) are feeling the pressure of an especially sharp cyclical downturn. Last Friday’s construction data showed an unexpected monthly decline in non-residential construction from September to October. Read the complete release from the Census Bureau. Both public and private nonresidential construction activity has been partially offsetting the residential downturn this year.

The monthly data are notoriously volatile and often subject to substantial revision. I’m more heartened by the fact that commercial construction was up 17.5% versus October 2006 compared to a year-over-year decline of 16.2% in residential construction. Nonetheless, tightening credit standards and growing vacancy rates suggest that 2008 will be weaker for non-residential construction. Unfortunately, I don’t think we’ve hit the bottom on the residential side.

Be sure to join me this Thursday for my Wholesale Distribution Economic Outlook webcast. I’ll give you more details on the 2008 forecast and its implications for wholesaler-distributors.

Private Equity Still Likes Distribution

The lead story in Monday’s NAW Smartbrief highlighted a recent Wall Street Journal article looking at drug wholesaler McKesson (MCK) as a possible takeover target. (See In McKesson, Some Foresee 'Value' Lesson.)

Despite the slowdown in M&A activity that I predicted in June, wholesale distribution will remain attractive to financial buyers. The prospects for a McKesson buyout highlight why private equity likes our industry.

Here’s a key quote from the WSJ article: “Rick Schnall, a senior executive of buyout firm Clayton, Dubilier & Rice, said McKesson has one of the best managements in the health-care business. He said "many private-equity firms would love to figure out a way" to buy it, though he said it is unlikely that such big deals will take place until difficulties in the credit markets pass.”

For those who don’t know, CD&R is a top-tier buyout fund that has been very successful with distribution businesses. They are currently invested in large distributors of electrical supplies (Rexel), lab supplies (VWR), food (US Foodservice), and building supplies (HD Supply). Click here to see a selection from their current portfolio. CD&R is one of the funds that I discuss in Chapter Five of Facing the Forces of Change®: Lead the Way in the Supply Chain.

I’ve been thinking about a drug wholesaler go-private buyout transaction for some time. As I see it, McKesson is the most logical buyout target among the Big 3 drug wholesalers due to its business mix, current operating platform, and age of the management team. McKesson has two distinct business segments – they are a drug distributor as well as the largest healthcare information technology company.

A buyout would provide a platform for a transformational restructuring and open up some intriguing domestic and international acquisition opportunities. Cardinal Health (CAH) is even more diverse but is in the midst of its own restructuring under new CEO Kerry Clark. AmerisourceBergen (ABC) is more narrowly focused on distribution but has a less centralized logistics platform, limiting its ability to serve large retail chains. McKesson’s acquisition of OTN improves the company's leverage with customers in the fast growing specialty distribution business.

McKesson also has very little debt due to the fee-for-service transformation that cut required wholesaler inventory levels in half. In fact, McKesson’s Net Debt-to-EBIDTA ratio was actually negative (!) based on second quarter financials, making the company especially attractive to private equity. (Net Debt = Short Term Debt + Long Term Debt – Cash & Cash Equivalents, so the numerator in this ratio is negative.) Keep in mind that a financial buyer is effectively purchasing the cash flow generated by a business and may finance the purchase by borrowing against the assets and future cash flows of the acquired company.

The drug wholesaling business has many risks, including ever-more powerful retail customers who squeeze margins and threaten to buy directly. Nonetheless, McKesson operates in a wholesale distribution line of trade that is insulated from global competition, just like other popular target industries for private equity such as facilities maintenance, construction supplies, and building materials. McKesson’s enterprise value is $17.1 billion, which is plausibly affordable once the credit markets settle down.

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Creative Ways to Own the Customer

Mark Twain once said: “History doesn’t repeat itself, but it does rhyme.” Keep that quote in mind when thinking through the possible lessons from some recent acquisition activity in the health care space.

McKesson (MCK), one of the country’s biggest drug wholesalers, just announced a deal to buy Oncology Therapeutics Network (OTN) for $575 million. I don’t normally blog about specific transactions. However, this acquisition highlights a very interesting counter-trend for wholesaler-distributors concerned about disintermediation.

Here's the twist. OTN is a distributor that also owns Onmark, a large buying group for thousands of small accounts. Now, the buying group portion of the business will be under common ownership with McKesson, a major wholesaler-distributor.

Such forward integration makes it virtually impossible for a manufacture to bypass and sell directly to the customer -- because the distributor and the customer are the same company! Nevertheless, the customers of OTN/Onmark still operate as independent businesses. McKesson is not planning to operate physician offices or oncology clinics.

AmerisourceBergen (ABC), a competitor to McKesson, uses this strategy to great success. ION, the largest community oncology buying group, has a prime vendor distribution arrangement with Oncology Supply. Both organizations are part of AmerisourceBergen’s Specialty Group.

Learning from Other Industries

As I see it, the McKesson deal provides an intriguing opportunity to think about possibilities in your own line of trade. I know that customer buying groups exist in many wholesale distribution lines of trade. So I wonder: Are there any similar opportunities to establish a unique competitive advantage through forward integration?

There are interesting lessons and examples like this one all around the $4 trillion wholesale distribution industry. So I also want to tell you about an upcoming opportunity to learn about these examples -- the NAW Executive Summit.

I’ll be leading a panel discussion on customer focus featuring three wholesaler-distributors from three very different lines of trade. I hope that you can make the time to attend and get inspired by the creative strategies of wholesaler-distributors in other lines of trade.

The Fallout from HD Supply

In June, I wondered if M&A activity in wholesale distribution was peaking. Well, I guess we don’t have to wonder anymore.

As you’ve surely read, Home Depot was forced to lower the price of its HD Supply unit by $1.8 billion and guarantee $1 billion of debt for the buyers – private equity firms Bain Capital, Clayton Dubilier & Rice, and Carlyle Group. HD Supply CEO Joe DeAngelo was “thrilled to be associated with this group of distinguished private equity firms.” (See HD Supply Deal Closes.)

Many big private-equity deals outside wholesale distribution are facing similar troubles because of so-called “turmoil in the credit markets.” Translation: lenders were taking on too much risk to buy companies that were over-valued. The Wall Street Journal’s Deal Journal summarized the status of many big deals last week.

But the renegotiation is not surprising given the sharp slowdown in revenues of building materials wholesaler-distributors. The chart below, which updates data from my NAW Economic Reports, shows double digit drops in revenues in 2007. The numbers look equally bad after adjusting for price deflation (not shown).

In chapter 5 of Facing the Forces of Change®: Lead the Way in the Supply Chain, I warned that industries do not consolidate forever, as evidenced by the sharp slowdown in acquisition activity after the peak in 2000. The current cycle began in 2004, as shown in Exhibit 5-1 of Lead the Way. The HD Supply deal signals the end of this cycle.

The next big shock will come if commodity prices return to historical levels, closing an inflation-led growth gap. For example, electrical wholesalers have been riding high on the price of copper for a few years and face an especially painful return to earth.

Bottom line: I suspect that valuations of wholesale distribution companies will return to more sensible levels over the next few years. Good news for companies looking to expand by acquisition, but bad news for sellers hoping to get out at the top.

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CORRECTION: In an earlier version of this post, I incorrectly reported that Joe DeAngelo had resigned from HD Supply. In fact, he has resigned his position as COO of The Home Depot but remains CEO of HD Supply. I apologize for the confusion.

Is M&A Peaking?

Modern Distribution Management just held a great audioconference on M&A trends in wholesale distribution. Read the provocatively titled summary Is the Market Too Hot?. (You can order a transcript and CD from MDM here.)

As I document in Chapter Five of my new Facing the Forces of Change®: Lead the Way in the Supply Chain wholesale distribution trend report, announced acquisitions have more than quadrupled in the past 2 years for wholesaler-distributors in construction, and industrial and commercial markets. (See Exhibit 5-1 on page 92).

In light of these trends, wholesale distribution executives should have a strategic plan for their business that recognizes the reality of acquisition activity, yet maintains a focus on profitable growth.

ARE WE PEAKING?

Wholesale distribution remains one of the top targets for buyout investments by private equity firms. These financial buyers are displaying a far greater ability and willingness to pay premium prices for leading distribution companies. They are being attracted by the ongoing need for wholesale distribution to end markets insulated from global competition, such as facilities maintenance, construction, or health care services.

The recent sales of HD Supply to a trio of private equity firms (Bain Capital, Carlyle Group, and Clayton, Dubilier, & Rice) shows the strong appetite for wholesale distribution. (See Home Depot Agrees to Sell Supply Unit for $10 Billion.) All three firms have made multiple investments in wholesale distribution over the years, although Chapter Five only discusses CDR.

However, the MDM panelists believe that this activity may have reached a peak. Brent Grover, a fellow Fellow of the NAW Institute, made some pointed comments about the market, stating: “I think there are some pretty unattractive companies that have been dressed up and the market figures out pretty quickly that it’s not the kind of firm they want to buy.”

Jim Miller of Vetus Partners, who I consider to be today’s leading expert on M&A in wholesale distribution, sees the market “…at or near a plateau.” Strong words from a major player. (Full disclosure: I am on the Advisory Board of Jim's new venture called Supply Chain Equity Partners.)

PLANNING YOUR FUTURE

The courage to face the future honestly often leads owners to look for a profitable exit strategy or even favorable terms for a recapitalization. However, acquisition dynamics should play a role in the decision, because industries do not consolidate forever, as evidenced by the sharp slowdown in acquisition activity after the peak in 2000.

Well-run, independent distributors continue to thrive even in consolidating industries due to their great skill in maintaining high levels of customer service and generating customer loyalty. One distributor summed it up in a comment that I include on page 94 of Lead the Way in the Supply Chain:

“I think [consolidation] will increase the value of the independent distributor related to servicing the customer and providing value to the vendor. The progressive independent will have a distinct service advantage. We will be more nimble and more reactive to local market conditional changes. It will raise the bar on the independent, however.”

Well said.