Are The Consolidators Losing Their Luster?
In the months following their 1996 initial public offering at $15, American Residential Services (ARS) stock rose steadily to an all-time high of $28 plus change. Industry consolidation seemed to be an idea whose time had come. Quite a few PHC contractors sold their businesses to ARS in return for stock valued in the 20s.
Nowadays those folks ooze the blues more than B.B. King. At this writing, ARS was hovering around $3 and hasn't topped $4 in recent memory. The chieftains who got ARS into this pickle were jettisoned with their golden parachutes, but in Wall Street's judgment nothing much seems to have changed - and what other judgment matters when you choose to live by that sword?
An extreme case to be sure. None of the other public consolidators is flirting with penny stock status like ARS. On the other hand, neither are any of them lighting up the Big Board the way their roll-up engineers had planned. It has been more than two and a half years since the first wave of IPOs and mass buyouts hit our industry. After an initial surge of investor enthusiasm for ARS and Service Experts, the first ones out of the blocks, their stocks have cooled off. None of the newcomers has made much headway either.
The graph below shows the stock price performance of public consolidators in the PHC industry through last year. The only one on a significant upward track is Building One Services (BOSS), due to a December merger maneuver that saw financier Leon Black buy back 34.5 million shares at $25. Even with the recapitalization, BOSS finished 1998 barely over its IPO price of $20. Stocks of the other PHC consolidators ended 1998 right around or below where they began the year. This in a year when the Dow rose 16.1 percent and the NASDAQ 39.6 percent. As of this writing, GroupMAC and ARS were selling below their respective IPO prices. The best performers, Service Experts and Comfort Systems, were muddling along at levels substantially below their peaks. Find an encouraging trend in this data, and you qualify as a White House spin magician.
(Although they are among the industry's largest mechanical contractors, I have excluded EMCOR from this analysis because of a different history than the roll-up consolidators, having emerg-ed from the JWP bankruptcy in 1994. For those inclined to lump EMCOR with the other consolidators, their performance adds fuel to the thesis of this article. EMCOR's stock price declined 21 percent last year and at this writing was selling for around $16.)
Writing about the stock market is risky in a monthly publication. This article dates back to early January. By the time you get the magazine in mid-February, things could look dramatically different. I'll take that chance. Whatever the short-term fluctuations in their stock prices, the longer trendline shows the consolidators to be losing their luster in the eyes of Wall Street. Let's try to figure out why.
What Are The Advantages? For a so-called roll-up strategy to make sense, the whole must be greater than the sum of its parts. Read the IPO prospectus of any consolidator and you'll find them defining the glories of consolidation to include purchasing economies, single-source services, the ability to service national accounts, best practices wisdom and brand name identity. But it takes an organizational game plan to achieve those things. Whatever progress has been made in any of those areas, it has not been enough to inspire more than a shrug of the shoulders on Wall Street.
Those folks aren't much interested in operational improvements, which tend to be incremental and pay off in the longterm. All they care about is whether they can buy a company's stock today at a substantially lower price than they can sell it for next week or next month. The corporate communications sent out by consolidators play to this quest for instant gratification. Their news releases highlight two recurring themes:
1. "We bought more companies. These companies represent $$$ million in sales and bring annualized sales to $$$ megabucks, with commensurate profit dollars. Bigger is better."
2. "We just increased our credit line. Bankers have agreed to up their credit facility by $$$ megabucks. This gives us more money to buy more companies. Bigger is better."
Consolidators need continuous infusions of capital to play with. They prefer to raise that money by selling stock, but when stock sales are lackluster, the companies have to borrow the money to get bigger. They could put up their own money, of course, but most consolidators are loath to do this. That would make them bettors. The consolidators are more like bookies. They make their money on the vigorish.
Short-term Thinking: Size alone isn't all that matters, of course. The Wall Street crowd is obsessed with arcane financial ratios, mainly over the short term, meaning the present quarter and whatever the tea leaves show for the next. The consolidators take great care to purchase only companies whose EBITDAs look good or can be massaged into shape. Investing money in long-term operational improvements runs counter to this imperative.
Case in point: one of the great apparent advantages of consolidation is the opportunity to use a fair share of those consolidated megabucks to put together a first-class technician recruitment and training program. Finding capable plumbers and service technicians is every contractor's biggest problem. A company that could successfully grow their own would have a tremendous competitive edge over everyone else. All of the consolidators have paid lip service to this principle and to varying degrees have training programs planned or underway.
Problem is, training and recruitment cost a lot of money, and the payoff is years down the road. There's also a good chance that the first company to make a sizable investment will end up supplying their competitors' manpower requirements as well as their own. Training is fun to talk about for the distant future. In the short term all that counts is EBITDA.
Illusory Economies: What about those economies of scale? Consolidators are cutting deals for insurance, vehicles, tools, uniforms, merchandise and equipment, etc. Genuine savings are being achieved, but two things must be kept in mind:
1. Suppliers have to make money, too. As a rule, the folks who supply goods and services to PHC firms are in hotly competitive businesses of their own. They do not enjoy windfall profit margins. They can shave perhaps 10 percent off the selling price for their biggest volume buyers, but there is a limit to how low they can go.
And furthermore, contractor affinity groups have been springing up in response to industry consolidation. These are organizations of independent contractors who have banded together for collective purchasing and marketing programs. Buying groups have enabled independent plumbing wholesalers to compete reasonably well with the billion-dollar empires that have arisen in that sector of the industry. Watch for the same thing to happen with contractors.
2. Big companies entail added expense. As organizations get big they add regional vice presidents and middle management staff. Also, a public company requires much more legal, accounting and other administrative staff than private competitors. And they often have to pay premium prices for the companies they buy. Much of the money the big boys save through economies of scale gets squandered elsewhere.
Strategic Visions: Like generals adept at fighting the last war, the roll-up experts may not be attuned to unique PHC terrain. Most of the players came here after consolidating the waste management industry. While that industry may bear some similarities to PHC contracting, there are also significant differences. For one thing, municipal waste hauling contracts deliver thousands of customers and millions in revenue at a crack. It's a much different business trying to round up customers one at a time for a few hundred bucks per transaction.
None of this is to say that these are not viable organizations. In fact, all are profitable. Even ARS managed to eke out a little black ink on the bottom line for 1997 and probably will do so again when the figures get released for last year. The other consolidators typically report net profit margins greater than 5 percent, about double the industry's average for privately-held companies.
So why aren't they doing better on Wall Street? It's because public companies get evaluated not on performance but on expectations. Internet sales companies report humongous losses quarter after quarter only to see their stock prices skyrocket, because investors see them as the wave of the future. PHC consolidators operate stable businesses, but the investment community seems to think they will never get any better.
Could be that they are simply confused about the lay of the land, because each consolidator has targeted different industry sectors. Service Experts is focused on residential-light commercial HVAC service. Comfort Systems is strictly commercial-industrial and pursues design-build construction along with service. The BlueDot. organization, which postponed its IPO last fall, spans the plumbing-HVAC-electrical spectrum but is focused on the residential-light commercial market. GroupMAC and ARS have gone the diversification route, trying to work plumbing-HVAC-electrical in both residential and commercial-industrial markets (although GroupMAC lately seems to be pointing itself increasingly at the commercial-industrial marketplace). Building One Services, a $1.2 billion company originally built around janitorial and electrical services, recently became a major player in the mechanical sector with the purchase of Ivey Mechanical.
It's always possible that one or more of these companies may hit on the right formula or do something brilliant that causes them to break from the pack.
It may also be that only one strategic vision is really in play. That is to build up a consolidated empire as large as possible in order to sell it to another consolidator, to a utility, to Home Depot or Sears, or to whatever other buyer comes along with deep enough pockets.