Over time, industries tend to follow a predictable path of consolidation, referred to as the "consolidation curve." Big companies are acquiring smaller companies using affordable capital to grow. This growth creates economies of scale. And economies of scale allow larger companies to provide goods and services relatively more efficiently and at a lower cost than their smaller competitors.
Consolidation will continue because it is a virtuous cycle where success attracts additional investment that generates further business advantage. A growing consolidator will continue to acquire for two main reasons. First, each acquisition presents an opportunity to further build economies of scale to propel further competitive advantage. Second, disciplined acquisitions increase the value of a business in excess of the cost of the acquisition. This is generally referred to as an accretive acquisition, or multiple arbitrage in the financial world.
The Stages of Consolidation
There are three stages of consolidation. Well, actually four, but the last stage represents stability rather than consolidation. The stages are:
- Stage 1: Fragmentation
- Stage 2: Acquisitions
- Stage 3: Expansion
- Stage 4: Maturity
Stage 1: Fragmentation
Industries begin in a highly fragmented stage. Depending on industry dynamics, some industries move very rapidly through this stage. In the collision industry, this stage has lasted for decades, but is rapidly changing due to internal and external forces previously discussed.
Leading companies in the initial stages of industry fragmentation focus on building a footprint. They are focused on establishing a “first mover advantage” in size and brand. These companies begin to develop an acquisition-based growth strategy. They focus on building revenues over profit growth. Growth comes in fits and starts. Acquisitions are often “one off” in nature and tend to be opportunistic. Companies are still perfecting their acquisition and growth strategies. Sometimes there are spectacular failures. At this stage, acquisitions are focused on enhancing revenues and expanding footprints.
Stage 2: Acquisitions
This stage is about rapidly building scale. Consolidation takes place rapidly in this stage. Major players begin to emerge from the chaos of a highly fragmented industry. Consolidated business models have been validated and leaders are able to attract capital. The major players begin to form empires, buying up competitors. The pace and frequency of acquisitions increase significantly. At this stage, the leading companies develop a core competency in acquisitions-based growth. The industry is still fragmented, but sizable players have emerged as clear leaders. The top three or four companies account for 30% to 45% of market share.
The type of company acquired also changes. One-off acquisitions that enhance revenue are still important, but maintaining the pace of growth and developing scale become the primary goals. For an acquiring company, the focus shifts to larger targets that provide both revenue enhancement and cost reduction opportunities. In this environment platform, acquisitions become more important. Platform deals tend to be much larger than the average one-off deal and often catapult a company into a new region. Platform acquisitions experience significant valuation inflation as they are important to active acquirers to maintain growth expectations. Acquisition targets, while generally still smaller in size than the acquiring company, tend to increase in size to better leverage cost reduction opportunities.
Successful companies in Stage 2 are companies that are excellent in both acquisitions and integration. Retention of the best employees in these organizations becomes much more important. Building scalable platforms like sophisticated operations management, integrated IT systems, and in-house employee training and development systems becomes important. Companies that survive to Stage 3 are those that acquire key competitors and build competitive advantage through successful integration.
Stage 3: Expansion
After the rapid (and often rabid) consolidation in Stage 2, the leading companies in Stage 3 focus on expanding their business to aggressively outgrow their competitors. While consolidation continues, acquisitions tend to become less frequent, but more focused. Acquisitions are often large scale mega-deals between remaining companies. By the end of this stage, top companies can control as much as 70% of the market.
Rather than buying one-off competitors, top companies shift their growth strategy to brownfield and greenfield development. One-off acquisitions become less frequent in nature because they do not provide sufficient revenue enhancements or cost reductions. They also become less valuable because by this stage buyers usually have built enough brand recognition to justify paying a premium for a seller's existing customer base.
Both brownfield and greenfield developments have higher financial returns and lower risks than most acquisitions. They are more common at this stage as the leading companies use them to “fill in the dots” in areas where they have not been able to find a suitable or affordable acquisition. They also provide more predictable growth, which is important to investors, especially in publicly traded companies.
At this stage, companies begin to focus more on profitability and core competencies developed in prior stages. Leading companies have already developed economies of scale, a recognized brand and an experienced management team. There is no longer a pressing need to acquire talent and invest in projects to build scale as there was in Stage 2. The pace of acquisitions drops substantially, as do the premiums paid to target companies. The credible threat of building a greenfield rather than paying a high premium to a seller keeps prices in check and provides substantial negotiating power to buyers. Companies that survive to Stage 4 are ones that aggressively grow in a disciplined and cost effective manner.
Stage 4: Maturity
Every industry eventually reaches a maturity stage where the acquisitions trickle to a standstill, growth moderates to a few percentage points a year and the market becomes fully developed. In this stage, a handful of dominant players will often control the industry. Examples of mature industries include pharmacies (domestically: CVS and Walgreens), aircraft manufacturing (Boeing and Airbus), automotive manufacturing (domestically: Ford, Chrysler-Fiat, Chevy), shipping (UPS and FedEx) and soft drinks (Coca-Cola and Pepsi).
Case Study - Automotive Collision Industry
The entire automotive aftermarket industry is consolidating. Dealers, tire vendors, parts distributors, paint distributors, software providers are all consolidating. Let's take a closer look at the stage of consolidation for the collision industry.
Stage 1 began in the 1990s with the formation and expansion of groups like Caliber, M2, CTA, ABRA, Boyd, CARA and Gerber, to name a few. These companies grew in fits and starts. Clearly some continue to succeed. Some failed miserably.
After the failures around the turn of the 21st century, Stage 2 began between 2005 and 2008. Service King began to grow in earnest and both Caliber and ABRA underwent significant recapitalizations. Stage 2 started calmly, but, much like a freight train, consistently gained speed and velocity. Both volumes and valuations of deals increased. Year 2014 was a hallmark in terms of both. And 2015, while relatively slower than 2014, experienced a very active year for acquisitions in North America. Is the collision industry in the middle of Stage 2, the tail end of Stage 2, or the beginning of Stage 3?
Seeking an Exit in a Consolidating Industry
Have you considered the stage of consolidation in your industry? More importantly, what are the implications to business owners at each stage? If you are considering a sale to a consolidator, what are the risks of selling later versus selling now? If you are considering growing like a consolidator, how will competition change? How do risks change in each stage?
But before I give you my opinion, I would like to know yours. Where do you see risks in your business and what are you doing to mitigate those risks?