The difference between mergers that flourish and those that fail is value. How do manufacturers maintain enough momentum to stay afloat in this rapidly changing environment?
When the book is closed on mergers and acquisitions in the automotive aftermarket later this year, 2006 may go down as the year of the well-known gun. Guided by veteran advisors, big-name companies and investors target original-owner operated companies with a distinguished track record and proprietary brands.
There is not another industry in the world where distribution has more power than in the automotive aftermarket, particularly in terms of the muscle that gorilla distributors wield over many manufacturers. But the landscape has changed most dramatically for several classes of manufacturers — particularly those selling through specialty distributors. Some are uniquely positioned to benefit from the wave of interest from private equity groups, while others will struggle to stay afloat or get swamped by the same rocky seas roiling their current or former customers.
In the first half of 2006, auto aftermarket mergers and acquisitions continued at a strong pace, as they have since the mid 1990s. Although total transactions in the year-to-date period ending June 28 decreased 4.4 percent from 2005's record-setting volume, the tally nevertheless represented a more than 30-percent increase over 2004. Broader U.S. M&A activity was also down moderately over the same period, with 2,030 transactions, or 2.1 percent fewer than last year.
Manufacturers continue to account for the largest percentage of auto aftermarket M&A transactions. At mid-year, 27 manufacturing targets were acquired — one fewer than last year — accounting for 62 percent of total aftermarket transactions as compared to 63 percent in the same period last year.
However, wholesale and retail deals fell significantly this year as a percentage of total aftermarket transactions, comprising just 26 percent of total transactions as compared to 32 percent over the same period last year.
Service and repair deals saw the only increase this year over last, making up 12 percent of total transactions as compared to 5 percent in 2005.
What are the underlying forces driving the continued interest in consolidation, and what does the aftermarket future hold for middle market manufacturers?
The big-picture trends affecting manufacturers, distributors and retailers are fairly easy to spot. Trying to predict how those trends will impact your business can be as iffy as predicting exactly where and when a hurricane will make landfall, but it's never a bad idea to be prepared.
Each distribution channel is being affected by significant trends in the capital markets, including the immense amount of private capital driving the record number of mergers and acquisitions in the industry. This domestic and foreign private capital has already gained a foothold and has had a great deal of influence on company valuations.
Winds of change
Currently, powerful market influences are conspiring to put the squeeze on manufacturers. On the production side, they can't compete with low-cost, offshore manufacturers. On the sales side, there has been a marked shift in distribution. Manufacturers are feeling tremendous pressure from both retailers and large WDs. Having been backed into a no-win corner, they are seeking new ways of distributing product. Less than 10 years ago, no manufacturer was willing to sell product over the Internet for fear of alienating customers. Today, that is no longer the case.
If, as coach Vince Lombardi once put it talking about football, "winning isn't everything; it's the only thing," then in the auto aftermarket, distribution is often the key to winning, keeping and growing business. Distribution has become the "game-changer" for manufacturers.
At the 2006 Global Automotive Aftermarket Symposium, a main theme was the inability of independent repair shops to identify needed parts due to SKU proliferation. New car dealers, on the other hand, can simply look up part numbers by using VINs, thus making the dealers the sole source for obtaining many parts.
Having been made aware of this new distribution angle and the cost savings of cutting out the middleman, many manufacturers now sell directly to the new vehicle dealerships, but in order to do so, some need to merge with a partner that already has this distribution in place.
Ripe for rollups
In an industry as highly fragmented as the aftermarket, such mergers can help smaller companies build value, and value is the name of the game in holding on to market share, staying competitive and remaining attractive to investors.
Many smaller manufacturers lack the capital to sell to more than one of the industry's multifarious channels. Rolling up several manufacturers who each specialize in different distribution channels diminishes the need for such capital and allows the rollup to reach more of the industry's existing nine or so channels.
We think sellers willing to continue (for awhile at least) to manage their companies and retain ownership in the rollup entity could benefit from this type of industry play. Financing is abundant for companies not overleveraged before the rollup. Plus, both debt and equity markets find the strategy appealing. Therefore, management that's willing to stay focused and invested post-merger will likely find their companies growing in value.
While there has been much consolidation among aftermarket manufacturers, there has yet to be a true rollup. We think it may be time. In a true rollup, small companies merge to reduce costs and gain competitive advantages, with their ownership pooled into a single entity.
In a successful rollup, the whole becomes greater than the sum of its parts. Owners have an incentive to stay and help implement the integration plan that delivers the synergy gains to the rollup.
The failure of management teams to implement post-merger integration plans with minimal deviation is the main reason half of all corporate mergers (rollup or not) fail to deliver promised synergies. Too often, management is asleep at the wheel.
It is our view that several niches of the auto aftermarket industry could benefit from a rollup strategy, most notably performance products and truck accessories.
A rising tide
Having all but abandoned the U.S. auto industry as a sinking ship, Wall Street has turned to the aftermarket as a better place to invest. Automotive in general gets a "negative" rating from Wall Street, while the aftermarket is rated "neutral." Many money funds like the aftermarket industry.
Interest from private equity groups as well as European, Asian and multinational investment shows no sign of slowing down. The continuing availability of capital has driven up purchase price multiples, but sellers need to ensure that their gross profit margins and earnings remain strong in order to be looked upon favorably by a prospective buyer. One of the best ways to do this is to continue developing (and protecting) proprietary patented products that meet the demands of niche customers.
Building a defensive strategy with other people's money and an acquisition program can't be accomplished overnight. Owners of $5 million to $10 million companies may not recognize that seeking investment-banking advice long before they think they might actually take advantage of it is as critical to the viability of their business as retaining a lawyer and accountant. There's a vast difference between making money and having value. Tremendous advancements in automotive technology have come with associated high costs in both human and physical investment, leaving many smaller and medium-size firms unaware that they have lost their competitive advantage until they simply stop making money.
By becoming larger through multiple product offerings, mid-level manufacturers have something to leverage against the buying power of their already consolidated retail and wholesale customers. Knowing how to use business-value drivers to take advantage of all the forces driving change in the aftermarket is key. So are long-term strategic planning and a realistic assessment of what their options are in terms of the capital market. When it comes to facing those realities, however, even some of the most highly sophisticated company owners may find themselves vulnerable. Some won't recognize the need to change until it is too late.
Boomer or bust
Many manufacturers or distributor owners are second- or third-generation principals closing in on retirement age with no succession plan. In many cases, selling out is their best solution. Fortunately, it is the enormous boomer, echo boomer and generation Y demographic that continues to steer money into the aftermarket industry.
The performance segment of the aftermarket industry is red hot, with many original owner-operated companies, such as B&M Racing and Performance Products, morphing from small entrepreneurial enterprises into organizations that are professionally managed, sophisticated and now backed by institutional investors.
Large, mostly public companies that have ventured into the aftermarket are finding they "don't get" the industry. Spin-offs from Dana, Arvin-Meritor, United Components, Remy International and others have generated interesting opportunities for both strategic and non-strategic buyers. We think there are more large company spin-offs coming — such as those from Delphi, Visteon, Federal-Mogul and others.
Right now, the auto aftermarket is the place to be for both buyers and sellers. By being prepared, both sides can be poised to catch the wave of this perfect storm and ride it all the way in to shore.
Dan Smith is president of the investment bank Capstone Financial Group, based in Hilton Head, S.C. Lou Merz is managing director of Capstone's Detroit office and president of Capstone Automotive Consulting, a division formed to work exclusively with aftermarket companies.