A Consolidation Primer
Here is a peek at some of the underlying premises of consolidation that should give you a better understanding of what’s going on.
1. Consolidation does not mean the demise of the independent. The waste management industry had about 11,000 firms when consolidation began around a quarter-century ago. Now there are about 9,000 companies engaged in that business. The consolidated giants like Waste Management and Browning-Ferris Industries (BFI) control a big chunk of market share, but plenty of niche players continue to prosper. So it will be in the PHC industry.
2. Consolidation is focused on the service business, not construction. A qualifier is needed here because some of the consolidators are happy to have some of their acquired companies continue to pursue profitable design/build and negotiated construction projects. For the most part, though, the consolidators are attracted to service-maintenance-repair. They turn their noses up at the tiny profit margins, big risks and lousy cash flow that characterize the construction business. They buy companies that do construction work, but only if they have a sizable service operation as well. In many cases they’ll phase out of the construction market.
3. Consolidators are mainly interested in big firms in metropolitan markets. If your business is centered in rural or small-town America, don’t expect a call from any of the consolidators. They want to establish a presence in the top 75 to 100 greater metropolitan areas in the U.S. They are not structured to operate in markets with a small population base.
Nor are the consolidators likely to come calling unless you produce respectable revenues. They look to buy companies doing at least $2–$3 million upon entering a market, although they might go after smaller firms as part of a local consolidation strategy afterwards.
In general, they look for firms with at least 8–10 percent net profit potential (after pro forma calculations that factor in bloated owner compensation and perks). Some contractors who are having trouble making it indulge in wishful thinking that the consolidators might be their salvation; be advised they aren’t looking to buy damaged goods.
Nor are they interested in buying firms where the owner wants to take the money and run, unless there is a respected number two person in place to manage the acquired firm. The consolidators have no management farm team. If the former owner or a key manager doesn’t agree to stay aboard, there’s no deal.
4. Consolidation is taking place in both the residential and commercial sectors. It started out mainly as a residential phenomenon, but not anymore. Service Experts has positioned itself as a residential specialist. Comfort Systems has gone the opposite route buying up only commercial-industrial service firms. All the others are trying to play in both sectors.
ARS has separated into residential (American Residential Services) and commercial (American Mechanical Services) divisions, while GroupMAC and the new ServiCenter USA are also buying up companies serving both markets.
5. Consolidation is largely - but not entirely - an HVAC phenomenon. The HVAC business has several elements that make it more appealing to the consolidators than plumbing and other service trades. HVAC offers more big ticket purchases and thus the opportunity to cut attractive purchasing deals, along with greater revenues per sale that lead to better economies of scale. HVAC also has minimal DIY retail competition. Nonetheless, Service Experts is the only consolidator that is exclusively HVAC. Comfort Systems is mainly HVAC, although I have heard that some of their acquired companies also do plumbing work. ARS and GroupMAC have purchased plumbing companies and even some electrical firms.
Take a look at the names the consolidators have chosen for themselves - American Residential Services, Service Experts, Group Maintenance America Corp., Comfort Systems, ServiCenter. All of them can accommodate any trade specialty.
6. The consolidated empires have many advantages over independent PHC firms. They have buying clout and the ability to pay top dollar for technical and management expertise. Most important, they have the potential to fill the industry’s large gap in nonunion training. The first consolidator to do this will enjoy a significant competitive edge not only over independents, but in relation to other consolidators and everyone else.
Another advantage is in sharing “best practice” operational techniques from companies they acquire. The consolidators can do things in-house that trade associations and franchises attempt to do for their members.
Also, the consolidated companies have the size and breadth for employees to grow professionally without leaving the organization. This is apt to attract good people away from the independents. In my opinion the most formidable threat from the consolidators will not be in the marketplace - there is plenty of business to go around - but in the race for talent.
In the commercial sector they will capture some national accounts that will result in a loss of business for local firms. They also are counting on some residential-commercial cross-referrals.
Eventually, all the consolidators want to establish themselves as brand names familiar to the public at-large. This may be a long way off, though. ARS has been the most aggressive of the consolidators in trying to change acquired companies to the ARS name, and that may be one of the reasons why their business has hit the skids. Most of the companies acquired by the other consolidators continue to operate under their old names.
With good reason. The value to buying Joe’s Plumbing Co. is the reputation and loyal customer base built up by Joe over the years. Yet, if ARS or GroupMAC are ever to become household words, their affiliates will have to take on their adopted parent’s identity at some point. It’s a tricky marketing problem for the consolidators. I’m not sure they’ll ever be able to pull it off the way they envision.
7. The consolidated empires have many disadvantages, too. Opponents always look 10-feet tall - especially when they are! Yet, the bigger they are, the harder they fall.
At this writing, ARS’s stock is trading at around $10, a third below its IPO price and far behind its short-lived peak in the high $20s. This isn’t to say they can’t recover, but it does point to the fickleness of Wall Street and the enormous pressure on public companies to dance a stylized minuet for the financial community.
Keep in mind that while its stock nosedived, ARS continued making money. Until the 4th quarter of last year when they wrote down some one-time losses, their bottom line had always been safely in the black. They simply hadn’t been earning as much as they’re “supposed” to. Their investors - most of whom don’t know diddly about the PHC industry - look only at the numbers, and when they fall short of expectations, they put their money elsewhere. This diminishes ARS’s ability to raise the funds needed to continue building their empire, which makes it that much harder to woo more investment. Cold-hearted stuff, this capitalism.
Much is made of the purchasing clout and economies of scale of the big public consolidators. On the other hand, they have extraneous expenses such as extra legal and administrative costs needed to comply with SEC regulations, and added layers of management and support staff. I suspect their overall cost structures give them little or no advantage over that of the average independent competitor.
Independents enjoy a great advantage in management flexibility. Decisions most contractors make over morning coffee might require weeks of committee meetings at consolidator headquarters. Think it’s hard to run a neighborhood PHC firm? It’s real easy to mismanage a billion-dollar national company.
Big question: How do you create a corporate culture from a network of entrepreneurs? And what happens when their three–year management contracts expire? Wave enough money in front of a contractor and you can buy his company. But we’ll have to wait and see how many end up giving their heart and soul to their new bosses.
8. Consolidation is a business unto itself. The brains behind the consolidation movement belong to Wall Streeters, not trade veterans. They have no special affection for the PHC business, except that it fits their profile of a fragmented industry ripe for consolidation. Before they came here they worked similar deals in the waste management and other formerly disparate industries. In a few years, after their instincts tell them they’ve squeezed all they can out of Wall Street from their labors in this industry, you won’t see them anymore. They’ll be out consolidating some other field. Don’t expect these wheeler-dealers to get weepy-eyed hearing your proud tale of your grandpappy starting the company out of a broken-down station wagon. They just want to know your asking price.
This doesn’t make them bad, just of a different business culture. To the extent that they bring a certain cold-bloodedness to the industry, it is balanced by the fact that the consolidators also represent the promise of enhanced opportunity and professionalism.
9. So far it’s been a big Wall Street game ... The consolidators are not operations people. Most don’t have a real detailed game plan for integrating the companies they buy into a cohesive organization. (Service Experts has a big advantage in this area thanks to their roots in the Contractors Service Group organization.) They make their money buying up firms, adding their revenues and profits to the collective P & L, and waving that in front of investors as corporate achievement. Silly as it sounds, it seems to work - to a point.
10. ... sooner or later, that’s got to change. There are only so many good companies out there worth buying and willing to sell. As the pickings grow slim - and the easiest purchases have already been made - it becomes harder to dazzle with smoke and mirrors. Pretty soon the consolidators will have to start impressing investors with growth from internal operations.
All of the consolidators have acquired or hired some great PHC management talent, but none really has experience managing such unprecedented national networks. Contractors and other executives who successfully ran $5 million to $20 million privately-held organizations suddenly find themselves in charge of public companies doing hundreds of millions in annual revenues, and managing a bunch of former entrepreneurs used to a lifetime of doing things their own way. A few ballplayers can handle the jump from Double A ball to the major leagues. Most find the curveballs too wicked.
The companies that get their operational act together will be the winners in the long run. They may end up owning some other consolidators who can’t deal with the curves. Like it or not, our industry is racing toward its first billion-dollar service empire - maybe more than one. I can’t predict all the ramifications. I just know that the PHC industry of the 21st century will be far different than that of the 20th.