Many distribution CEOs ask us how they can raise their companies’ valuations—and with good reason. Of the 52 publicly traded North American distributors in our database, about 70 percent have multiples below 10x, well below today’s S&P 500 average of about 13x.
A few leading distributors are much more appealing to investors, with multiples topping 15 times (Exhibit 1). They’ve broken away from the pack, improving multiples by about 5 points in the past decade while most competitors stood still or lost ground.
What have these outperformers done differently?
At a fundamental level, multiples are driven by growth, operating profit and invested capital. In other words, distributors with better prospects for profitability and revenue growth and/or return on invested capital should trade at higher multiples.
But that’s not the whole story, and for many multiple expansions remains elusive. For example, we know of several distributors that have by all measures delivered on all elements of the “multiples” equation: beating Wall Street expectations for growth and synergies, expanding revenues at double digits annually for the past decade, and growing both EBITDA and ROIC, but have seen their multiples either stagnate or decline relative to 2013 levels.
To understand why investors, reward some distributors differently, we reviewed three years of top distributors’ earnings transcripts, interviewed experienced industrial and distribution segment analysts, and read investors’ reports from major financial institutions.
We confirmed that top distributors and investors focus consistently on growth, margins, and capital efficiency, in line with the financial equation described above—but with nuances. Within growth, for example, investors look for consistent organic growth, recurring and stable revenue, regular market share gains, and diversification. In considering margins, they look for above-average returns and profitability, long-term margin expansion that indicates good pricing and cost discipline, and value-added services and products that protect against margin dilution. For the leaders, capital efficiency is about returns on invested capital and the strength of the balance sheet.
Distributors’ strengths in these areas collectively link closely to their multiples (Exhibit 2). Each company has different starting position and market conditions, of course. But we find that most outperformers fit into one of four archetypes:
- Rockstars: These large distributors are firing on all cylinders in markets worth more than $200 billion. They have significant headroom for growth due to market fragmentation, and tailwinds or trends that support organic growth. They have a diversified set of end markets and exposure to new sales and service opportunities that protect them from cyclicality; they offer specialty high-margin products and value-added services and maintain strong pricing discipline. They have impressive track records of performance—expanding profitability and growing faster than the market over many years, and strong ROIC positions. Examples include Fastenal, which has consistently been rewarded with multiples of more than 18x over the past few years.
- Heavyweight champs: These at-scale leaders are up to ten times larger than competitors in focused markets of under $100 billion. Like rockstars, they serve diversified end markets with exposure to new sales and services that protect against cyclicality, benefiting from secular growth trends and delivering strong records of performance and ROIC. Examples include SiteOne and PoolCorp, which have benefited from multiples of over 15x the past few years.
- Concierges: These are among the three largest distributors in their markets worth more than $200 billion. With wide assortments of products and categories, they play a true broadline distribution role compared to specialty distributors and provide attractive value-added services that drive customer stickiness. They have significant headroom for growth, with diversified end markets and beneficial secular growth trends, and strong records of performance and ROIC. These distributors could be similar to rockstars but tend to have some cyclical exposure and lower market share growth, margins or ROIC. Examples include Grainger and Ferguson, which have benefited from multiples over 12x in the past few years.
- Triathlete: These are among the top distributors in their market, with sustained history of financial performance. They are highly active in M&A and benefit from secular growth trends, but they are not the number one at-scale player, multiple times larger than competitors, nor are they playing in very large markets with breadth and depth of categories and end-market exposure. They have some but not all of other outperformers’ strengths, earning rewards for consistent performance over the years. Examples of this archetypes include Sysco and O’Reilly who have benefited from multiples over 10x in the past few years.
So how can leadership teams raise their companies’ multiples?
The more we study these outperformers, the more we see that they have taken steps along their journeys to anchor them into one of these archetypes. We found that any distributor can use these guiding principles to raise their appeal to investors and thus their multiples:
- Own your space: For a specialty distributor, it is all about becoming the undisputed number one supplier in its niche market, similar to SiteOne or PoolCorp, and being known for something. On the other hand, a broadline distributor, with breadth and depth of categories, needs to scale up and take advantage of its headroom for growth, similar to what Grainger and Ferguson have done over the years. Specialty and broadline distributors should use programmatic M&A to drive value creation—and not just be content with the occasional large acquisition or steady organic growth. We find over and over again that meaningful inorganic growth requires building an M&A muscle and an effective playbook with five to ten small to medium-size deals a year—of less than 30 percent of the acquiring company enterprise value—less frequent big bets.
- Change what’s not working: Distributors should proactively diversify their end-market exposure and expand into less cyclical markets and product categories through targeted acquisitions and/or category introductions. We recommend balancing the mix of recurring (e.g., repair and remodeling) vs. one-time revenues, shifting portfolio mix away from commodities by doubling down on specialty products and services (such as prefabricated trusses, design, or custom in building materials distribution), and riding pockets of growth in markets with tailwinds.
- Years of performance are a must: One or two years of profitable growth is not enough. To believe that a company has turned a corner, most investors look for several years of consistent share gains, growth more than 200 basis points faster than the market, and expanding profitability significantly, which for some types of distributors can mean expanding profitability by as much as 200-400 bps, all while keeping SG&A costs in check. For most companies, this requires changing the way people work. Sales reps, for example, need to move from being order-takers to thought partners and solution providers. They need to adopt analytically driven insights as gospel (e.g., customer share of wallet, white space, and churn propensity, among others), and get serious about building pricing and procurement capabilities to achieve and maintain competitive advantages and protect margins.
- ROIC is king: Every outperformer excels at capital-efficient growth, which requires a business model that leverages capital as the company scales. The winners today apply analytics to inventory and network to deliver year-on-year improvements.
In conclusion, we believe that every distribution company can improve its performance, its market exposure, and its “unique” story to attract investors and expand multiples. The proof is in the marketplace. Many distributors have achieved step-change improvements in multiples by shedding low-multiple business units, for example, or by expanding into a market with high secular growth, or by consistently innovating and showing strong financial outperformance year after year.