9 Characteristics of a Good Acquirer
I do like the aphorism “history doesn’t repeat itself, but it often rhymes”, attributed to Mark Twain. A deep understanding about situations occurred in the past can provide insights about what could happen in the future. From an investment perspective, it is always an interesting exercise to analyze what are/were the best performers, try to identify their main characteristics and then look for those attributes in new companies. Of course this exercise is not guarantee of future success, but it will probably put the odds on our side.
This article, as stated in the title, relates to acquirers and intends to be a compilation of the best traits or practices identified after analyzing many companies involved in acquisition activities, providing with real examples of specific companies in order to better understand how those characteristics materialize in real life. Those characteristics can be summarized as follows:
The intention of this list is not at all to be an exhaustive compilation, but just to highlight what are some of the main characteristics encountered in companies that have outperformed over the years and where acquisitions played a relevant role. In the end, trying to look for companies showing all these characteristics would be probably a worthless exercise. The idea is more to be used as a checklist, where probably those acquirers presenting a higher number of these features will have greater probability of success.
1. Fragmented markets with a relevant pipeline
This might be a truism but serial acquirers need a fishing ground of potential acquisitions to deploy their strategy over time. Analysts must understand how big and fragmented the landscape is, how the market share is distributed within the industry and the intensity of the competition. The bigger and more fragmented the playing field, the longer the time the company will be able to apply its strategy and compound returns over time, and the lower the competition the better the acquisition prices.
Pool Corporation (POOL) is the perfect example. POOL is the world’s largest wholesale distributor in the swimming pool industry and its acquisition strategy focus mainly on expanding its market presence by acquiring sales centers in different geographies. Those are generally little targets that are too small to achieve scale economies and with limited competition to acquire them, making the company the reference buyer. This provides the ideal scenario for a consolidator like POOL where a highly fragmented market gives the opportunity for the company to achieve and benefit from scale economies.
Onewater Marine (ONEW) follows a similar strategy but in the marine industry (deep dive here). ONEW is one of the US largest marine dealership groups and its strategy focus mainly on acquiring dealerships in order to expand its market presence. There are other companies that follow a similar strategy (e.g. MarineMax HZO) but in any case there is also little competition:
Xpel (XPEL) is also a very successful and interesting case with its “Get Close to the Customer” strategy. XPEL is mainly a provider of paint protection films in the automotive industry and realized that local presence helped them to build on the base of customers and to drive adoption and penetration of its products. In that sense the company started to acquire installers and distributors for their products, carrying out some sort of vertical integration. Those installers/distributors are again small operators within a very fragmented market and with little or no competition for their acquisition.
2. Evidence of real synergies and economies of scale
The best acquirers are those that are able to add value to the target company. In other words, those companies that, after the merger, can increase the value of the merged company above the combined value of the two separate firms.
These value increases are the result of synergies, such as cost savings due to operational efficiencies or revenue-enhancing synergies. With regard to cost synergies, large companies usually are able to leverage economies of scale, resources, employees or operating capabilities in a way that is difficult for smaller competitors to replicate, and the acquirer can operate the acquired company more efficiently and reducing its operating expenses. Revenue synergies materialize when the acquirer can expand the products/services range of the acquired business, reach new geographies or better exploit its customer base.
ONEW is again an interesting example. As already mentioned, ONEW acquires marine dealerships but not all of them, at the time of the acquisition, provide the complete range of products that ONEW provides. Marine dealership industry is composed mainly of mom-and-pop operators which carry out boat sales but don’t have the resources to carry out non-boat sales operations as finance and insurance, repair and maintenance services, or parts/accessories provision. ONEW is able to provide all these additional high-margin services once a new dealership is acquired, rapidly increasing its revenues and profitability.
TopBuild (BLD), the largest installer and distributor of insulation products in the US, might be another useful example in terms of cost synergies. BLD is an expert on acquiring other installers and distributors, and on integrating them within its network and improving those businesses after the acquisition. BLD is capable of consolidating the back office and corporate functions of the acquired company, integrate the supply chain and operating systems, optimize the branch network and realize the benefits of scale and buying power, making possible to rapidly improve the performance of acquired businesses.
3. Purchasing and pricing power
In close relation with the previous point, as a result of the economies of scale, best serial acquirers tend to enjoy some power within their supply chains. This basically means that the industry presents low buyer group power or low supplier group power (or both, in the best-case scenarios). Those are cases where there is a relevant fragmentation among the acquirer’s customer and supplier base, or when the position that the acquirer holds within the supply chain is so important that it is able to exert some power over its suppliers and customers.
SiteOne Landscape Supply (SITE), the largest national wholesale distributor of landscaping products, may help to better understand this idea. The landscaping products market has thousands of suppliers trying to reach more than half million customers and this situation makes highly-valuable the presence of a wholesale distributor to connect them. SITE is the only distributor of scale that provides the full range of products and services that professional landscape contractors need. This situation makes the power of suppliers and customers to be rather low, and places almost all the power on SITE.
POOL is also a good example of a company that plays a prominent role within the supply chain:
POOL places itself at the center of the supply chain and the beauty of its business model is that it is able to make the selling process much more efficient for manufacturers and retailers, creating a win-win-win situation, where all of them (manufactures, retailers and the company itself) benefit. This unique and prominent position within the supply chain gives the company the capacity of passing cost increases along its channels with no impact on demand. This is an extraordinary feature under any environment, but it is even more appreciated in the current situation where above-average inflationary product cost increases need to be passed through.
4. Strategic financing and financial strength
This is a controversial issue and there is probably not a one-size-fit-all strategy, however the best acquirers tend to present two characteristics: a well-defined financing strategy and financial strength.
With regard to the definition of the financing strategy, this should be part of a broader definition of the whole acquisition strategy (that will be commented in the next paragraph) but the most relevant issues are the statement of a target net leverage range and a clear understanding of the different implications of the use of cash, debt and equity to carry out the acquisitions. Best acquirers tend to avoid dilutive acquisitions and use the right mix of cash and debt.
With regard to the financial strength, best acquirers usually present both a capital structure and a capacity to generate cash flow which provide them with the flexibility to execute their acquisition strategy. Those companies tend to look for a balance between the strength provided by a reduced debt burden and the positive impact stemming from the financial leverage derived from the use of external financing. This means basically that most of these companies make use of some kind of debt (it is rather uncommon them to be net cash positive), but at the same time they try keep their debt levels well under control (usually around 1-2x target net leverage range, though this is highly dependent on the company and industry). They tend to establish specific debt ranges that are frequently exceeded in case of a new acquisition but that serve as financial objectives that try to recover as soon as possible.
For instance, in the case of ONEW, the majority of purchase considerations are paid mainly with cash flow from operations and debt. ONEW produces cash enough to partially fund its roll-up strategy and, for the remainder part, it is able to access to favorable financing conditions (~3% interest rate) and to keep a reasonable leverage ratio:
As it can be observed, ONEW shows a fluctuating leverage ratio, in line with the cadence of its acquisition strategy, but always tries to keep it under reasonable levels and within its target limit of 1.5x.
There are other companies that, due to the specificities of their business model or industry, are able to work with higher leverage ratios, taking greater advantage of the financial leverage. TransDigm Group (TDG), a global producer of aircraft components, is a good example. TDG is company operating with leverage ratios averaging 6x but, due to its durable business and long-time positive free cash flow, they feel rather comfortable under those debt levels and that they are convinced that they could even withstand more debt (but they prefer to have flexibility enough to keep deploying its acquisition strategy). This capacity gives them the advantage of fully exploiting its financial leverage:
This kind of companies can produce outstanding returns on its acquisitions and therefore to generate huge shareholders returns. TDG share price has compounded 20+% CAGR since 2006 and this is without taking into account distributions, that would probably increase CAGR over 25%. However, it is important to make clear that those debt levels are usually a warning signal and few companies can successfully operate under these stretched conditions.
5. Well-defined acquisition strategy and disciplined approach
Best acquirers tend to be those companies that approach acquisition activity not as a succession of individual deals, but as an integral part of their strategy. Those companies usually have teams specifically dedicated to this activity and well-defined playbooks that cover the whole process: from the screening process, helping the company to better select potential targets and keep an active pipeline; to the acquisition process itself, clearly establishing how to select and analyze the candidates, make the final decision and close the deal; and to the complete integration of the acquired companies.
There are multiple companies that could be used to illustrate this characteristic, but let’s use the case of Converge Technology Solutions (CTS). CTS is a Canadian IT & cloud solutions provider and a relevant part of its growth approach is based on a M&A strategy to expand coverage all across US and Canada. The company follows a well-structured and detailed acquisition strategy where the whole acquisition process is taken into account:
The company makes clear what are its key targets, metrics and integration approach. This is for sure something that needs to be carefully monitored, but at least provides the company with a clear path to follow and investors with something to check against.
Watsco (WSO), the largest distributor of HVAC products in America, might be a good example of a discipline company. WSO has acquired 66 HVAC distribution businesses since 1989, typically paying 4-6x EBITDA, while WSO itself traded at double digit EBITDA multiples. This seemingly simple strategy has yielded incredible results: WSO have returned 20+% compounded TSR over the last 30 years by buying at those favorable prices and then integrating and growing a large number of businesses in its niche.
6. High employee and management team retention
Best acquirers tend to look for well-run companies and to integrate their management teams and employees within the organization and, in case of decentralized approaches, try to keep them at the helm and leading the business. This is usually a winning strategy as it helps to add talent to the team and keep customer relationships.
Two interesting examples of this approach are Gypsum Management & Supply (GMS) and ONEW. GMS, a US distributor of interior building products, follows a strategy to expand its geographic footprint based on accretive acquisitions combined with greenfield opportunities. With regard to the acquired businesses, GMS deploys a “local go-to-market strategy”, taking advantage of the national scale of the company, but keeping the brand of the acquired businesses and, whenever possible, making the original leadership team to continue leading the business.
ONEW follows a rather similar approach. ONEW’s strategy seeks to retain key staff, including senior management, and dealer’s branding in order to create as low disruption as possible in the acquired dealerships. Indeed, as states in its Form S-1, “the operational management of our boat dealer groups is decentralized, with certain administrative functions centralized at the corporate level and the primary responsibility of day-to-day operations localized at the store level. Each store is managed by a general manager, often a former owner, who oversees the day-to-day operations, human resources and financial performance of that particular individual store”. This strategy aims to retain the goodwill and customer relationships of dealer groups and helps their smooth integration.
7. Strong alignment
Though this is applicable to every company and not only to acquirers, those acquirers showing better results tend to be companies where there is a strong alignment between management and shareholders. Analysts must deep dive into executive compensation and insider ownership looking for hints of strong alignment, like preference for equity-based and performance-based compensations, long vesting periods for time-based compensations, and high levels of executive ownership.
Wastco (WSO) can be used again as a good example:
This company’s long-term incentives program is mainly composed of restricted stocks that vest toward the end of the employees’ career (“this means our key leaders do not know and cannot realize the value of their restricted share awards until they have spent their respective careers with the Company”) and indeed, with regard to their Named Executive Officers (NEOs), they boast about “none of (their) restricted share awards have ever vested”.
TransDigm is also an interesting case. This company limits its equity-based compensation exclusively to performance-based options, avoiding any other stock award or time-vested options. The idea is to link as much as possible the equity component of management’s compensation to long-term stockholder value creation. In that sense, “the intrinsic share price must grow at a compound annual growth rate of 10% for any vesting to even occur at all; for 100% vesting, the intrinsic share price must grow at a compound annual growth rate of 17.5%”.
With regard to beneficial ownership, many of the last years best-performer acquirers show significant financial stakes hold by their executives (in percentage or in dollar terms):
As it can be observed, in many cases the amount dependent on the market value of the stock is rather significant, creating a strong alignment between management teams and shareholders.
8. Diversification
Best acquirers tend to use the acquisition strategy to create stronger structures through diversification. Acquisition strategies allow them to penetrate into new or adjacent markets and expand their presence in the existing ones, broadening their product offerings. Those strategies usually create stronger organizations that are much more resistant under downturns.
XPEL is the perfect example of this approach. This company started initially focused mainly on paint protection films in the automotive industry and limiting its geographic reach to the US and Canadian markets. In 2014 the company began its international expansion by establishing an office in the UK and since then it has been focused on expanding its geographical reach and increasing its customer base to drive revenue growth. Nowadays XPEL sells and installs a broad range of after-market products in different industries beyond the automotive sector (e.g. commercial and residential real estate, marine industry) and all over the world, and has become a much stronger organization that is able to offset potential declines in some parts of the business or geographic areas with increases in others.
Installed Building Products (IBP), one of the largest real-estate insulation installers in the US, is another good example. This company started in 1977 as an insulation company and in the late 90s it began its acquisition strategy with the goal of creating a national platform. Since then the company has carried out over 125 successful acquisitions and has been able to diversify its service and product offering. IBP currently provides, apart from insulation products, closet shelving, shower doors and bath hardware, rain gutters and many other building products for the residential and commercial end markets, resulting again in a much more diversified and resistant company.
9. Seasoned management
Last but not least, one of the main common denominators of the best acquirers is that they tend to be companies led by executives who have run this playbook before and show a proven track record of acquisitions.
HEICO (HEI), one of the largest providers of aircraft and electronic replacement parts, is a perfect example of this kind of companies. Acquisitions are a relevant part of its growth strategy and since 1990 (year of CEO Laurans A. Mendelson appointment) they have completed more than 90 acquisitions and as the CEO recalled in one of his conference calls they “have never had a failed acquisition. Some of them better than others, but (they) have never had a failed one”.
TransDigm (TDG) is another company with a really impressive track record in terms of acquisitions. Though this company has recently (in 2018) transitioned its CEO, it has a long experience of successful acquisitions and integrations (mainly under the helm of the previous CEO Nick Howley that led the company from 1998 to 2018 but remains as Chairman of the Board):
There are many other companies that could be included as part of this “experienced” group (e.g. ONEW, SITE, FERG, IBP) but the relevant point is that this is an important characteristic to look for: those companies and management teams with seasoned acquisition experience tend to outperform those “occasional” acquirers.