Consolidation Game’s Only in the Middle Innings

By Tim Triplett, Editor-in-Chief

If service center consolidation were a baseball game, what inning would it be? About the fourth, say most executives, suggesting that industry M&A is not even halfway complete.


Attention Mom and Pop: Don’t Expect the Big Guys to Buy Your Company

Seller’s Perspective: ‘They Gave Us the Buying Power We Needed to Compete’

Independent’s Perspective: Consolidation’s Little Threat

While the economic slump has caused a metaphorical rain delay in most service center M&A activity, the pace of play should be brisk once the sun shines on the U.S. economy again, experts say—whenever that is.

“The current economic situation is a consensus forecast of less than 3 percent GDP as far as the eye can see. That means no growth in steel demand—not a terribly encouraging outlook for investors,” says Charles Bradford, principal of Bradford Research in New York. “Equity values have gone down a lot, and I am not sure the prospective seller is willing to take the lower price. People may have overly optimistic values for their companies today.”

“The economic uncertainty is not good for M&A,” says Bill Jones, chairman of O’Neal Industries, Birmingham, Ala. “Acquirers are more cautious. There is plenty of capital available. It’s just a matter of confidence.” Sellers are busy doing what they can to improve their profitability and position their companies for sale, he adds. “This is just the second year of the economic turnaround, and most know they need another couple good years so they have a positive multi-year story to tell.”

Lorenço Gonçalves, president and CEO of Metals USA, Fort Lauderdale, Fla., considers the current transitional market a potentially good one for M&A. “When conditions are really bad, owners don’t want to share their low numbers [because buyers will demand a lower price]. When conditions are really good, owners have an artificial expectation [of what their companies are worth]. I like where we are right now. This is a moment when good companies can deliver great results that are interesting to acquirers like Metals USA. The good targets are the ones surviving well in this environment. It is very difficult to disguise a bad company today,” he says.

Most companies in the service center industry are privately owned and operated and only become available when their owners decide to sell, notes Dave Hannah, chairman and CEO of Reliance Steel & Aluminum Co. in Los Angeles. “Most people in our industry lost money in 2009, but made money in 2010 and 2011. As business conditions improve slowly, and business owners start to record better numbers, that could drive them to sell. As long as they remain dissatisfied with their operating performance, they won’t be looking to sell because they doubt they can get the price they deserve for their companies.”

The Great Recession of 2009 reset the market, but emotions have lagged behind, adds Don McNeeley, president of Chicago Tube and Iron Company, Romeoville, Ill. “People who were close to selling when the market was booming were left with an inflated multiple in their head. Some time had to pass before the emotional reset could occur. I think in the next two or three years you will see people come to the realization of what their companies are really worth.”

Is the industry shrinking?

Exactly how many service centers have changed hands in the past few decades is unknown, but the deals certainly number in the hundreds or more. Does that necessarily mean the industry is getting smaller?

“We get this question a lot: Is it really consolidation if you acquire a company like EMJ with 40 locations and today they have those 40 and 10 more? I say it is,” asserts Hannah. “Consolidation is the discipline that comes from having fewer owners out there, and fewer players to muddy up the market. Companies like Reliance can bring new products, more inventory and greater processing capability to a market and make it operate more efficiently. Bringing added value to
customers is good for the marketplace overall and makes for a healthier industry.”

Consolidation of ownership does not necessarily mean consolidation of facilities. Metal is heavy and costly to move. Distributors can only service customers efficiently within about a 150-mile radius, Hannah notes. “There is consolidation and then there’s rationalization. Mills, like banks, have rationalized a lot of capacity, but that has happened among service centers to a lesser degree.”

And the service center industry continues to see new entrants. “The same rationalization that results in facility closures can also breed new, small players who see opportunity in regional niches,” he adds.

Tight credit is no longer a constraint to service center M&A, says Jones at O’Neal. “Large companies can get money easier than smaller ones, of course. Banks are doing more due diligence. But for companies that have a good track record and a good strategy, capital is available.”

Most financial buyers, such as private equity firms, are in a wait-and-see mode, but not so for strategic buyers like O’Neal. “When we see a company that is a good fit, we try to make it happen regardless of what is going on around us,” Jones says. “With all the uncertainty out there, a strategic buyer is going to be more confident to get a deal done because the strategy should work in any scenario.”

Midsize service center operators—those in the $50 million to $250 million range—are the most threatened by industry consolidation, agree most observers. “The companies that will find the biggest need to reinvent themselves, or to sell out, are the ones in the middle,” Jones says. “Small companies can still operate very effectively in niche markets and do well.”

A case study in consolidation

Chicago Tube & Iron is a prime example of a midsize company that foresaw its best future as part of a larger entity. Chicago Tube was acquired by Olympic Steel in July.

Chicago Tube is a major player in the tubular products sector, but at $230 million in annual revenues, it falls in that vulnerable midrange among service centers of all types. “In the past five years, we have encountered more and more large customers looking for purchasing efficiencies. What could a tubing specialist like CTI do to compete with the general line guys? All I could offer them was tubing,” says McNeeley. “We successfully differentiated by incorporating sophisticated engineering and fabrication. However, a successful organization must eventually consider the next stage of its evolution.”

Olympic Steel offered the ideal fit as a merger partner, he explains. There was no overlap between the product lines of the two companies, which will continue to operate independently. Now CTI can refer customers to Olympic for sheet and plate, and Olympic can refer customers to CTI for pipe and tube. “The merger allows me to go to customers and offer the full line of products (with the exception of structurals),” McNeeley says. “It will allow us to bring more efficiencies to the marketplace in the form of transportation, kitting and one-stop shopping.”

The deal was also an exit strategy for CTI’s majority owner Bob Haigh, who was ready to retire. Factoring into the timing of his decision was the capital gains tax. “The owner of a sole proprietorship or partnership today has a 15 percent capital gains exposure. In our lives we will never see capital gains this low again,” McNeeley says. This tax consideration, in combination with the ready availability of capital, will stimulate an acceleration of consolidation, he predicts.

Buying co-op’s perspective

Lonnie Terry, president and CEO of the North American Steel Alliance, has witnessed the consolidation of the industry firsthand as both a service center executive and head of the industry’s leading buying group. The consolidation trend has generated some turnover within NASA—but also some opportunity, he says.

NASA is an industry cooperative that gives small and mid-sized service centers collective buying power. Over the years, mergers involving NASA members have caused companies to leave the group. Reliance Steel & Aluminum alone bought up 14 former NASA members. But there are always new prospects looking to join. NASA currently has 102 member companies and a long list of potential applicants, Terry says.

The existence of NASA gives service center owners an alternative to selling out, he notes. “What we have seen in recent years is a tremendous interest by small and mid-sized guys moving into the arena with NASA, rather than divesting.”

Will consolidation eventually run its course?

With what sense of urgency should sellers pursue a deal? Will there eventually be a tipping point at which the major acquirers have achieved national coverage and seek no further acquisitions? That’s possible, say the experts.

“At that point, the geographic consolidation motive will yield to vertical integration,” predicts McNeeley. “Rather than buy a second service center in a market, companies will go out and buy an engineering company or a fabricator, or look for opportunities internationally. That’s where I think the next wave of consolidation will occur.”

Reliance has already considered vertical integration—looking upstream or downstream for investment opportunities—but plans to stick with its distribution strategy. “Most of our customers are small fabricators and job shops. If we get too far downstream in processing, we could end up competing with our customers” he says.

Looking upstream, acquiring a mill offers similar conflicts. “As big as we are, we could not take 100 percent of the product of any mill I know. So we would be dependent on other service centers. Owning a mill is probably not a good idea, either,” he says.

For the vast majority of service center owners, talk of billion dollar mergers and vertical integration by the big players seems far removed from the small ball they play each day. As a group, small, independent niche players still command the majority share of metals distribution in North America. “The service center industry will never be an industry controlled by a few, like the automotive or steel industries,” says Terry at NASA. “At the end of the day, the service center business is local.”


Attention Mom and Pop: Don’t Expect the Big Guys to Buy Your Company

The service center industry is still largely populated by small “mom and pop” operations, those with less than $20 million in annual sales and just one or two locations. Such companies do not offer the critical mass that attracts the big acquirers. What do major players like Reliance, O’Neal and Metals USA seek in an acquisition?

“We prefer to do transactions over $100 million in revenue—the bigger the better,” says Dave Hannah at Reliance Steel & Aluminum. “If we buy a company with $25 million in revenue, even if they have triple the return percentage we require, they would get lost in the numbers.”

“The larger you get, the less interested you become in the smaller acquisitions,” says Bill Jones at O’Neal Steel. “There are certain aspects of an acquisition that are the same amount of work, no matter what the size. We like to find those niche companies that tuck in nicely with something we already have or help us move into another market where we think we can grow.”

Potential acquisitions must be of substantial size, agrees Lorenço Gonçalves at Metals USA. “If it doesn’t move the needle for Metals USA, then we really don’t bother. At the end of the day, the effort it takes to integrate the company is pretty much the same whether it makes $1 million or $10 million of EBITDA a year.”

Valuation’s an art form
Valuing a potential acquisition is as much an art form as it is a math problem, say executives, especially considering that most companies are still recovering from one of their worst years ever in 2009.

O’Neal does not penalize prospects for their performance during the recession, but it might reward them, says Jones. “We don’t skip over 2009 because of the recession. We like to see how a company did. We don’t expect them to have done well, but we look to see if they have a company that stands up defensively in a really down market.”

O’Neal and Reliance consider a company’s past performance, but largely disregard its forecasts. “We look back as far as we can on company history, but when we look forward we rarely look at the information we are given. We do our own pro forma. If they had a really super year in the past or a really bad year in the past, we tend to weight that more toward the middle,” Jones says.

Likewise, sellers’ forecasts of future earnings carry little weight with the Reliance team. “We will look at what they expect to do, but I have never seen a forecast that anticipates a decline,” Hannah says.

Potential synergies, such as added buying power, economies of scale or savings on insurance, are not considered in a valuation by Reliance executives. “We think if we cause those synergies to happen, that value belongs to us. We do not factor synergies into our transactions,” Hannah says.

Synergies that fail to materialize are the reason so many mergers are unsuccessful, he adds. “Many acquirers get caught up in the transaction and will make whatever assumptions are necessary to justify the purchase price they must pay to get the deal done. To fill the gap between where the company is already performing and the level needed to justify the purchase price, they just assume there are synergies. Most of the time that is unrealistic.”

Market’s current multiples
Market multiples currently fall in the range of six to eight times normalized EBITDA, Hannah says, explaining the thought process behind each Reliance purchase. “When we look at a deal, we look at that company’s performance over many years, through a cycle at least, concentrating on pretax income. We relate that to our own performance. We look at how that company is organized, how they operated in a tough time, how they operated in a good time. Based on our feeling about their particular market, products or geographic area, we come up with a number that represents how much pretax income that company could produce in most years. We call that normalized pretax income, and that is the number we value from. It’s not just a calculation, it’s not just an average, it’s a gut feel.”

Don McNeeley, president of Chicago Tube and Iron Company, which was recently acquired by Olympic Steel, expects industry multiples to normalize around seven times EBITDA—but he urges sellers to look beyond that simple number. “People are playing a lot of games with multiples: Is it pretax, net, a one-year trailing average, was goodwill part of the deal? It is getting less transparent as time goes on. When you hear a multiple, you really have to drill down to see how it is defined.”

Unlike most other buyers, Metals USA’s primary goal is not national market coverage, but strictly return on investment. “We are not driven by geography. We are not driven by product. We are driven by EBITDA, improving our return to shareholders,” Gonçalves says. Metals USA’s goal for growth through acquisition is to expand at an annual rate of 10 percent. “We have a clear strategy to acquire, integrate, extract synergies, make the accretion to show in the earnings per share number, then move on to the next one.”

Like Reliance and O’Neal, Metals USA shies away from distressed companies. “We’re not good at turnarounds. Turnarounds are difficult and time-consuming. In this M&A environment, it is much simpler to acquire good companies that can be integrated more easily,” adds Gonçalves, echoing most other acquirers.


Seller’s Perspective: ‘They Gave Us the Buying Power We Needed to Compete’
Dave Deinzer, former president and CEO of Denman & Davis, Clifton, N.J., is among the owners of midsize service centers who have opted to cash out. Denman & Davis was purchased by O’Neal Steel in January 2010.

“One of the reasons I ended up selling was that I found the small to medium-sized service center could not compete on the buy side,” which is based solely on volume today, Deinzer says,

The volatility of steel prices makes the service center business uncomfortably risky, he adds, pointing to a six-month period last year when the specialty plate price plummeted from $1,400 down to $520 a ton. “Strategically, I did not think we would be able to compete with the new supply side in the game.”

Denman & Davis saw its best year in 2008 with $63 million in sales. “O’Neal bought us for geographic reasons because they had no coverage in the Northeast. They gave us the buying power we needed to compete with some of the larger guys, and we gave them the strategic locations they needed. It was a good marriage,” Deinzer says.

Selling to O’Neal was in the best long-term interest of Denman & Davis and its employees, Deinzer says, yet he remains convinced that the small, independent service centers that make up the majority of the industry still have a promising future. “The smaller niche players who stick to their knitting will always have a place in the market because they have relationships and are close to their customers. Customers prefer to buy from people they know and like,” he says.


Independent’s Perspective: Consolidation’s Little Threat
Berlin Metals, Hammond, Ind., is an example of a small, successful Midwestern service center whose owner is content to remain independent—at least for the time being. President Roy Berlin does not feel that his company is threatened by the M&A trend. With about $55 million in annual revenues, and healthy profitability, Berlin is content to stay the course. “The larger companies don’t take care of small to mid-sized customers the way their smaller competitors do. We service the hell out of these customers,” he says.

Berlin Metals is a niche player focusing on tin mill products, and stainless steel, light-gauge and cold-rolled strip. It offers a continuity and reliability that its larger competitors can’t match, he claims, citing delivery as an example. “If I were a big company, I probably would not want to be 99 percent on time with deliveries because that would mean I have too much inventory, but as a smaller private company I can afford to do that.”

Berlin has contemplated becoming an acquirer, perhaps growing his company to the point it would be large enough to catch the eye of one of the big buyers. But at this point in his career, and in his late 50s, he is reluctant to take on the debt. “At this stage of my life it’s not worth the risk,” he says.

Berlin is skeptical that the end result of the consolidation trend will be a market controlled by just a handful of mega service centers. More likely, he says, the market will polarize, with large players concentrating at the high end and small ones at the low end. “It’s the middle zone that will get hollowed out,” he predicts.

Indeed, Berlin feels the market needs consolidation. Mills have merged, customers have merged, and service centers in the middle have lost bargaining power. “Consolidation is a good thing. It improves efficiencies and reduces redundancies and makes service centers more competitive as an industry,” he says.

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Thursday, February 22, 2018