The roll-up gambit should result in a whole greater than the sum of its parts; why hasn't it?

Several years ago, in a spasm of stupidity, I bought a modest amount of stock in various roll-up consolidators that had erupted in our industry. From an investment standpoint, I probably would have done better using the money to buy lottery tickets; however, a secondary purpose was to keep tabs on those companies from a shareholder's perspective. At least that paid off with receipt of a recent mailing from the Sheet Metal Workers International Union, which like me, owns shares in Comfort Systems USA.

The SMWIA was surveying shareholders to see whether they would support an initiative to forbid the company from granting executives new stock options without shareholder approval. This was in response to a revelation in Comfort Systems' 2000 proxy statement that the company had reissued 300,000 options to five executives because "the previous options granted to these individuals were at exercise prices significantly higher than the year-end 2000 market value."

Said SMWIA: "Stock options are supposed to link executive compensation to a company's stock performance . . . In our view repricing or replacing underwater options not only reduces executives' incentive to work hard for shareholders, but also in our view tends to mislead shareholders about the true value of an executive's compensation."

The Other Side Of The Story

I share that sentiment and decided to look into this. Suspicion arose of some Enron-type shenanigans with favored insiders chewing a carcass clean before tossing the bones to hapless shareholders and employees. After talking with Comfort Systems' Chief Financial Officer Gordon Beittenmiller, I don't think it's that type of story at all. It does, however, provide food for thought about the roll-up craze that disrupted our industry like an obnoxious house guest.

Beittenmiller said the reissue of options was in fact approved by shareholders, even though the Board had the right to do so unilaterally. Beneficiaries included not only the five executives mentioned in the proxy statement, but also plenty of field managers and other personnel. The proxy statement cited only the five executives because it had to in accordance with SEC rules. Altogether the company reissued more than 3.9 million options, according to its CFO.

This came about during a housecleaning period for the company, whose stock price had plummeted more than two-thirds from $21.12 at the time of its annual meeting in 1998 to $6.75 in 2000. In response, the company replaced its founding CEO and closed some operations, but were fearful of tossing out the baby with the bathwater. "The company wanted to keep those people it saw as valuable, and to do that the board felt it needed to offer certain incentives," Beittenmiller told me.

No doubt the company did risk losing valuable individuals. Good people tend not to stay aboard a sinking ship. Stock options are supposed to induce people to stick around, but that doesn't work without reasonable hope of the stock price gaining enough ground to make the options worth something. Granting new options is a way to revive the incentive mechanism.

However, what's all this say about the consolidation wave that hit our industry six years ago?

Anemic Stock

Comfort Systems is the only roll-up consolidator still in business under its original identity. The rest have been merged with or sold to other organizations, and the roll-up artists who formed them mostly have departed to pursue other interests. What kind of legacy have they left behind?

Comfort Systems consists of around 80 operating units nationwide. Those operating units represent independent mechanical contractors bought by the company, most of which still operate under their original names in their local markets. Through three quarters of 2001, Comfort Systems' revenues were around $1.2 billion with net income of $10 million. That tiny 0.9 percent profit percentage represents an improvement over the $586,000 loss for the same period in 2000 and the $16.8 million worth of red ink the company reported for the entire year.

Unfortunately, there's one score that counts more than anything else with a public company. As of Jan. 18, shares of Comfort Systems were trading at $3.71, down by almost half from the previous year's already anemic level. A stark but logical interpretation is that Wall Street doesn't have much confidence in the company's future.

Plenty of talent still exists in this organization. Comfort Systems purchased some of the best mechanical contractors in the country. Many of the key people are still around, and they haven't forgotten how to build and fix mechanical systems in exemplary fashion. It's just that from a business standpoint, they were more successful doing so as independent mechanical contractors than as part of a billion-and-a-half-dollar company with tentacles coast to coast. How come?

For consolidation to make any sense, the whole is supposed to be greater than the sum of its parts. Joining scores of companies into one entity was supposed to result in advantages they didn't enjoy individually. The consolidators spoke of the glories of purchasing power, economies of scale, sharing best practices, training resources, better pay and benefits to attract top talent, the ability to service national and regional accounts, and brand name recognition. In theory, it sounds like a powerful package, but the execution simply wasn't there with Comfort Systems -- or with any of the other roll-up companies.

Putting it all together is the duty of top management. In every case in our industry, they failed. Maybe it's because they really didn't try. The roll-up leaders knew nothing about mechanical contracting. They were Wall Street gamers. They never had any intention of sticking around long enough to fulfill the excruciating details of building a coherent operating company. Their objective was simply to cash out higher than they bought in.

Can It Be Done?

A lot of buzz around the industry holds that large corporations can't make it in mechanical contracting. As evidence, people point to the demise of so many companies that once topped the list of mechanical contracting volume leaders -- Sam P. Wallace, Natkin, JWP. This conventional wisdom says big overhead burdens spell doom when markets turn down, and that entrepreneurial savvy counts for everything in this business.

I don't completely buy this argument. Just because something hasn't been done, doesn't mean it can't be done. Consolidation is taking place at every level of the PHC industry, as well as in most other industries throughout the U.S. and globally. There must be some economic logic to this trend. Bigness does have certain benefits, and at least one huge company in the industry seems to be doing something right. The industry's current volume leader, Emcor, draws rave reviews from Wall Street and saw its stock price approximately double last year.

Perhaps the biggest distinction between Emcor and the floundering giants is that Emcor has always been operated by people who are at home in the mechanical contracting business (along with electrical and facilities management). As we were going to press, news came that EMCOR has agreed to purchase 19 of Comfort Systems' subsidiaries.

Big is not necessarily better, but let's not forget the famous dictum of Peter Drucker, probably the greatest management consultant and writer who ever lived: "Grow or die." Growth is part of the natural progression of business. Sooner or later someone in this industry is going to figure out how to do it right.