Sweating equity

Yep, it’s that time of year again. Everyone is working overtime to shoehorn 2020 into neat lists that make sense out of the most nonsensical year of your life.

Need a rundown on the best books of the year according to a random sampling of CEOs, VCs, and Ivy League professors? Bloomberg Businessweek has you covered. How about Barack Obama’s favorite TV shows? Swing by Medium and grab them straight from the source.

Curious how Peyton Manning ranks the best movie quarterbacks of all time? Don’t laugh; the Wall Street Journal saw fit to dedicate space to this list. And if we’re talking football, we can’t ignore NFL players who should have made the Pro Bowl roster but didn’t. Never mind that there will be no Pro Bowl game played this season. Outrage over injustice doesn’t require any actual injustice.

But if you were thinking the LBM channel might be spared, you would be wrong. The other week Craig Webb of Webb Analytics published his “10 for ‘20: The Year’s Most Significant Events in LBM.” It’s a good list; no argument here about Craig’s choices. But you’ll notice right away that six of the ten are M&A-related.

That’s because COVID-19 isn’t the only plague sweeping the planet right now. We are also smack in the middle of the mother of all M&A booms.

“The past five years have been ones of unprecedented success for the private equity industry,” says Bain Capital’s Hugh MacArthur in the company’s Global Private Equity Report 2019. “During that span, more money has been raised, invested, and distributed back to investors than in any other period in the industry’s history.”

(Executive Council members: Get a copy of Bain’s report HERE; sign-in required)

The Financial Times reports that Q3 2020 was literally “the busiest third quarter on record” for global M&A activity “as bankers raced to make up for a dearth of activity at the height of the coronavirus crisis.” The U.S. averaged 9,371 deals per year from 1985 – 2014. In 2019, 17,759 deals were closed according to the Institute for Mergers & Acquisitions. From January through November 2020, 13,352 deals were closed—despite a two-month shutdown for the pandemic.

In the LBM channel, the big event by dollar volume was the merger of Builders FirstSource and BMC Stock Holdings announced in August. That deal should close any day now. When it does, BFSBMCSBS (unlikely that they’ll use that acronym, but we can hope) will be the first true nationwide construction supply chain since Wickes Lumber in the 1970s, with facilities in 43 states and $11.1 billion in revenue including BMC’s December purchase of T.W. Perry.

But No. 1 on Webb’s top ten list was Bain Capital’s purchase of a majority stake in US LBM. At $3.5 billion in 2019 revenue, US LBM was reportedly one of the larger holdings in the portfolio of its former owner, Kelso & Co. At Bain, US LBM is one of the runts of the litter. No one thinks Bain will be content to leave it that way.

Actually the buying spree has already started. US LBM acquired Zeeland Lumber (MI) Nov. 2nd, followed by Ridgefield Supply (CT) Dec. 9th, Tri-County Building Supplies (NJ) Dec. 17th, and Jennings Building Supply (NC) Dec. 23rd. Word on the street is that we’ll see another flurry of deals as soon as the holidays are over, with more to come throughout 2021.

That makes it a very Happy New Year if you’re an independent in need of an exit strategy. In fact, you may be sitting on the strongest seller’s market you’ll ever see in your career.

According to Bain, the feeding frenzy is draining the pool of attractive acquisition targets. PE firms “are clearly hungry to do more deals, but when they find attractive assets, they consistently encounter aggressive corporate buyers willing to push up auction prices.”

All this activity has some wondering whether the M&A boom may ultimately be an extinction-level event for independent lumberyards. You can never say never, but so far it doesn’t look like it. The Census Bureau lumps lumberyards and specialty dealers (e.g., window & door or K&B showrooms) into NAICS 44419. The latest economic census, in 2017, put the headcount at 22,793 firms.

There’s no breakdown available, but there has been in the past. Going back as far as the 1997 census, lumberyards have always made up 23% to 24% of the total. If that percentage is still valid—and there’s no reason to think otherwise—it means there are somewhere between 5,200 and 5,500 lumberyard firms in the U.S.

Most of them aren’t acquisition targets. Due diligence and other purchase-related costs don’t change much with the size of the transaction, so the smaller the seller, the more expensive it is to do a deal. Different buyers obviously think differently, but generally speaking, the ideal lumberyard candidate does over $100 million in annual revenue. Anything less than $40 million starts to get iffy.

Judging by the trade magazines’ annual rankings, chances are there are no more than 250 lumberyard firms nationwide with sales over $40 million. That’s less than 5% of the total even if every one of them was willing to sell, which they aren’t.

If US LBM intends to catch BFSBMCSBS, the question is Who are they going to buy? You can help. Click the image to go to the survey page, then check the companies you think might be willing to sell. The page will keep a running total of the dollar value of your choices so you can see what it’d take to get to $11 billion in revenue.

250 targets may be enough to keep US LBM busy for a while, especially if it also continues to beef up its specialty distribution businesses—which it is doing. But Bain needs an exit strategy, too.

Right now Bain’s investor presentation feels a bit weak: “We’ve got a wonderful opportunity for you that is a distant No. 3 in the low-margin lumber business and a middle-of-the-pack player in roofing supply—and by the way, it carries a B rating from Fitch, which means ‘highly speculative’ and one step above ‘a real possibility of default.’”

Fitch Ratings’ Dec. 23rd assessment of LBM Acquisition, LLC (US LBM’s holding company) was not the report card you’d want to bring home: “high leverage levels” (6.6x net debt-to-operating EBITDA) and “low EBITDA and FCF (free cash flow) margins,” plus “low brand equity” and “limited value-added product offerings” that give US LBM “little competitive advantage relative to competitors of similar or greater scale.”

Fitch also dinged US LBM for its “substantial exposure” to “highly cyclical end markets,” namely new construction, which accounts for 82% of its revenue. That “weighs negatively on the credit profile when compared to other building products suppliers with more stable end-market exposure.”

On the bright side, says Fitch, US LBM offers “a comprehensive suite of products” and enjoys “good financial flexibility following the close of the acquisition by Bain Capital.”

Some of this criticism can’t be helped; it’s just the nature of the beast. Fitch would like to see US LBM generate more revenue from remodelers, for example, because it views the R&R market as “less cyclical than new construction.” It is, but R&R is a different business. You can’t supply both markets effectively with the same infrastructure. If your only objective is a bigger footprint in a non-cyclical business that sells products to contractors, you’re better off buying liquor stores.

Some of the criticism is just plain curious. Fitch’s bitch about “low brand equity” seems to suggest that it believes a company of US LBM’s size should have a unifying brand name (ideally with a catchy acronym like BFSBMCSBS) that reinforces the perception of a marketplace powerhouse.

Likewise, its comment about “little competitive advantage” relative to other chains suggests that it sees US LBM’s deliberately decentralized structure not as a source of responsiveness, but an obstacle to synergies and economies of scale.

Most insiders would say that in this business, a local brand carries more weight than a national name—and that local decision-making is necessary to tailor your offering to the unique quirks of your market. If Fitch’s comments are an accurate reflection, apparently the PE community thinks Bain bought a fixer-upper.

You might think so, too, looking at the publicly-available financial data. But the numbers are a little misleading. In 2018, US LBM spent a lot of money setting up an IPO that never happened. Its adjusted EBITDA, which excludes those one-time expenses, is right in line with publicly-held LBM chains.

Which is not to say good, at least by independents’ standards. High-performance independents are consistently booking better unadjusted EBITDA than the chains’ adjusted earnings. Even strictly average dealers are hitting 3% to 4% net margins these days.

Actually it’s unrealistic to expect anything else. In a small company, everyone has a direct connection with the lead dogs who set the pace. In a large company, that connection is diluted. You can build systems to teach entrepreneurship—e.g., US LBM’s Six Sigma program—but no system can match the power of day-to-day interaction with the company’s lead dogs. The bottom line is that US LBM is holding its own versus its peers. The question is what Bain will do with it.

That’s probably no secret. Bain laid out in detail what it considers to be the optimal investment strategy for a seller’s market in its 2019 Global Private Equity Report, and the acquisition of US LBM appears to fit that strategy like a glove. 

“Buy-and-build,” as Bain defines it, starts with a platform company—in this case, US LBM—that then pursues “add-on” acquisitions on an ongoing basis. “Serial acquisitions allow GPs (the PE firm’s general partners) to build value through synergies that reduce costs or add to the top line,” argues Bain. “The objective is to assemble a powerful new business such that the whole is worth significantly more than the parts.”

Sounds impressive, but even Bain admits that buy-and-build is not an easy strategy to pull off. “Value creation depends on a steady cadence of acquisitions,” notes the report, which in turn requires “an ample supply of targets and a stable environment in which to pursue them.”

The apple cart can easily be upended by destabilizing factors beyond the control of the consolidator. In a sector prone to severe boom-bust cycles, for example, “ping-ponging demand can wreak havoc on free cash flow.” The potential for “large-scale technological disruption is another factor,” and “supplier or customer consolidation can upset the best-laid plans.”

And while 250 targets may qualify as an ample supply, US LBM isn’t the only one chasing them. “Smaller companies consistently trade for lower multiples than large ones,” notes the report, “offering an opportunity for multiple arbitrage” that “brings down the firm’s average cost of acquisition.” Stiff competition—for example, BMC reportedly paying top dollar for T.W. Perry in December—could blow that strategy out of the water.

Most important, all those serial acquisitions need to be financed by the platform company, not the PE fund. “The PE fund is theoretically a backstop,” says Bain, “but few GPs are willing to throw good money after bad if the well runs dry.”

US LBM clearly has its work cut out for it. The good news is that it appears that the environment is likely to be cooperative. Most analysts believe that pent-up housing demand is strong enough that a severe crash isn’t in the cards for a while.

Which raises a question: If you don’t need an exit strategy right now, why hang up your party dress just as the party is about to start?

This is a perfect time to cash out if you need to do it, and obviously there are plenty of reasons why you might. But one of them should not be concern over your ability to run with the channel’s big dogs.

Roll-up consolidation is a risky proposition in any industry—so much so that the Harvard Business Review included roll-ups in a famous list of “Seven Ways to Fail Big.” HBR says “research shows that more than two-thirds of roll-ups have failed to create any value for investors.”

“The bet underlying a rollup is that it can reduce costs and drive growth to create enormous value,” says Strategy + Business. But to make it happen, you need to “alter the modus operandi of the acquired companies, ensuring that they operate not as a loose confederation but rather as a large and cohesive institution.”

It works in some industries. But in a business where half of the revenue comes from open market commodities and the rules of the game—building codes, construction practices, preferred products and services—vary from market to market, a large and cohesive institution is the kiss of death.

That’s why chain operators in construction supply (not to mention home builders) all allow greater local autonomy than chains in other industries. The only difference is that some do it overtly while others are quiet about it.

Local autonomy doesn’t mean there are no synergies or economies of scale to be had, but it does reduce them. That’s why this business has never seen a chain with the horsepower to outmuscle a large, well-run independent on its own turf. In any given market, success depends on the strength of local managers and their teams.

It appears that the channel is about to see another round of roll-up consolidation, but the potential to transform the competitive landscape won’t come from serial acquirers. It’ll come from key employees at acquired companies who come to the conclusion that the view really is always the same unless you’re the lead dog.

They’ll strike out on their own, but without the backing of pension funds and university endowments, their only option will be to invent new ways to reduce costs and create value. Some will make it and others won’t, of course. Those who do will become the next generation of attractive acquisition targets.

If you want to worry about whether you’re going to be able to compete in the long run, those are the folks to worry about.

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